Rising yields creating long-term value; near-term hinges on U.S.-Iran

Key Takeaways

• The recent rise in U.S. Treasury yields is the result of a confluence of factors – most notably, oil-related inflationary pressures, a hawkish shift in global central bank policy expectations, and resilient U.S. economic activity driven by robust AI-related investment, improving employment trends, and a steady consumer.
• In the background, mounting concerns around fiscal deterioration – driven by persistently large deficits and rising global debt burdens – are putting upward pressure on long-term yields and are likely to keep interest rates “stickier” at the long end of the curve.
• We maintain our more favorable view of duration. The recent move to higher intermediate yields improves their forward-looking total return outlook. Higher income generation also creates a powerful offset during periods where rates move higher.

What’s driving yields higher

Since the start of the Iran War, U.S. Treasury yields have spiked to their highest levels in over a year. The 2-year Treasury yield recently hit a high of 4.12%, up 75 basis points (0.75%), while the 10-year Treasury yield touched to 4.67%, up 73 basis points (0.73%) from just prior to the conflict. On May 19^th, the 30-year yield touched 5.19%, its highest level since 2007. While inflation concerns have provided the primary catalyst, it is not the sole driver behind the move in interest rates.

Inflationary pressures

• Energy is the key driver. Supply chain disruptions in the Middle East have pushed oil up roughly 50% since late February, which is feeding into inflation. Oil is a central input to major sectors of the global economy.
• Inflation data is firming. The headline Consumer Price Index (CPI) rose 3.8% year-over-year in April, the highest level since mid-2023. Additionally, longer-term measures of inflation expectations have crept higher.
• Supply chain risk remains elevated. The longer that major bottlenecks persist along key trade routes and production hubs, the more that concerns around the future path of inflation will likely grow and create periods of rising yields, both in the U.S. and abroad.

A hawkish shift in central bank policy expectations

• US: expectations for Federal Reserve (Fed) rate cuts have faded. Markets now expect the Fed to remain on hold, with the potential for a rate hike. However, we believe the bar for a rate hike this year remains high.
• Europe: expectations have shifted toward multiple rate hikes to offset inflation pressures tied to the conflict.
• On balance, monetary policy is likely to stay tighter-for-longer and preserve elevated yields globally until a durable peace agreement is reached and the Strait of Hormuz reopens.
  • If tensions ease: The Fed could resume gradual rate cuts, pulling short-term yields lower.
  • If tensions persist: The Fed likely stays on hold unless the labor market weakens meaningfully.

Fiscal deterioration still matters

• Large deficits, elevated government spending, and rising debt levels across developed markets are increasing concerns around long-term sustainability. This dynamic creates an underlying pressure that can keep longer-term interest rates higher than otherwise dictated by growth, inflation, and monetary policy.
• Investors are demanding higher yields as compensation for these risks, particularly in longer maturities (10- to 30-year maturities).
• Despite these concerns, U.S. Treasuries remain the safest and most liquid market globally, and debt levels, while high, are still currently manageable.
• Even with a geopolitical resolution, fiscal pressures are likely to keep long-end yields relatively sticky, favoring the return of yield curve steepening over time.

The good: The U.S. economy remains resilient

• Investment activity remains strong, especially in AI and technology-driven capital expenditures.
• The labor market remains firm, even as it gradually rebalances.
• Consumer spending is holding up, supported by health balance sheets and steady income growth.
• Net: Despite a more challenging global, backdrop, the U.S. economy is on solid footing. That strength can contribute to higher rates, but it also helps businesses and consumers absorb external shocks. 

Bottom line

Our base case scenario suggests U.S. yields should fall from current levels with an assumption that persistent inflation worries ease in the coming months and the Fed does not raise policy rates. Additionally, if interest rates continue to rise, adverse impacts on the economy would likely become more readily evident, thus exerting downward pressure on rates.

We maintain our more favorable view of duration. Elevated starting yields have created an attractive starting point for investors to add duration to portfolios, especially for portfolios that are concentrated in areas like cash, money market mutual funds and ETFs, or ultra-short fixed income securities.