Key Takeaways:
Wall Street strategists are warning that even a peace deal between the US and Iran won't bring long-term borrowing costs down, as the bond market reprices for a new era of structural risks.
Even as crude oil prices fell Monday on reports of a potential US-Iran deal to reopen the Strait of Hormuz, bond strategists cautioned that the era of elevated interest rates is likely to persist. The primary drivers of the recent surge in long-term borrowing costs are structural economic forces, not just geopolitical inflation fears, according to analysis from ING Bank, Goldman Sachs, and Barclays. The US 10-year Treasury yield, which neared 4.7 percent last Tuesday before settling at 4.56 percent on Friday, is being held up by factors that a diplomatic agreement can’t erase.
“A reopening of the Strait would cap inflation expectations, but could leave real yields elevated, and if so, then Treasury yields don’t collapse lower as many currently anticipate,” Padhraic Garvey, regional head of research for the Americas at ING, said. He calculates that the “entire” break in 10-year US yields beyond 4.5 percent has come from higher real yields, which strip out inflation expectations.
While crude oil futures fell in early Asian trading and Treasury futures rose on the peace overtures, the moves did little to change the broader market narrative. A Bloomberg analysis shows that rising real yields explain most of the move higher in overall US yields, while inflation expectations have had a more limited impact. In contrast, rising breakeven rates have accounted for most of the increase in 10-year yields in Japan and Germany since the start of the war.
The dynamic suggests that even if the conflict-related energy shock subsides, persistently high borrowing costs will continue to pressure governments and economies. “The bond market is not reacting to one headline,” Mark Malek, chief investment officer at Muriel Siebert & Co., wrote in a client note. “It is repricing a structural problem that cannot be solved with a press release or diplomatic pause.”
The argument that the global bond selloff is primarily about war-driven inflation is “hard to square with market pricing,” according to Jonathan Hill, head of US inflation strategy at Barclays. He points out that 10-year breakeven rates in the US remain 50 basis points below their peaks in the first half of 2022, when the Federal Reserve was aggressively hiking rates. “Instead, the interaction between rising debt levels, potentially higher neutral rates, and AI could be driving real rates higher,” Hill said.
This view is reinforced by a dramatic shift in rate expectations. Having started the year betting on multiple Fed cuts, traders now see a non-trivial chance of a rate hike in 2026. This repricing has occurred even as the five-year, five-year breakeven rate, a proxy for medium-term inflation expectations, has held steady around 2.2 percent. At Bank of America, economists are watching how the long end of the yield curve becomes more sensitive to fiscal deficits and rising debt service costs, which could be exacerbated if the Fed is forced to tighten policy further.
Beyond the Fed, Wall Street is increasingly focused on a trio of structural pressures: fiscal deficits, heavy Treasury issuance, and the capital-intensive AI boom. JPMorgan Chase CEO Jamie Dimon warned last week that US interest rates could climb much further, citing concerns over government borrowing and the demand for its debt. This is a direct consequence of policies like former President Donald Trump's proposed tax cuts, which would swell an already large debt burden and require more Treasury sales.
“Persistent fiscal deficits, more Treasury issuance and concerns over debt sustainability increasingly explain why investors are demanding extra compensation to own long-term debt,” Phillip Lee, head of real money rate sales at Goldman Sachs, said on a company podcast. “I think rates are going higher.”
The investment frenzy surrounding artificial intelligence is also seen as a new inflationary variable. While AI may boost productivity in the long run, its immediate effect is to increase demand for resources like semiconductors and energy for data centers, fanning price pressures. Furthermore, the economic growth spurred by an AI boom could make equities more attractive than bonds, forcing asset allocators to demand higher yields from fixed income to compensate. This combination of factors has led some to conclude the underlying neutral rate of interest for the economy has permanently shifted higher, meaning the 5 percent yields on 10-year Treasuries may no longer be a bargain.
This article is for informational purposes only and does not constitute investment advice.
