Beyond the Fed: The rise in long-term yields

• The recent steepening in the U.S. Treasury yield curve has been driven primarily by rising long-term yields via higher term premia rather than falling short-term yields. This distinction is important because it suggests investors are focusing on fiscal sustainability, rapid U.S. government debt issuance, and inflation uncertainty rather than imminent changes to monetary policy.
• Short-term U.S. Treasury yields remain relatively anchored by growing expectations that the Federal Reserve (Fed) will remain on hold with a restrictive policy stance over the very near term. Economic growth has moderated but remains positive, reducing pressure for either aggressive tightening or rapid easing.
• While higher long-term yields can be uncomfortable in the short run, they improve forward-looking return potential for long-term investors. We continue to view intermediate-term duration favorably, as higher starting yields have historically been one of the strongest predictors of future fixed income returns.

The U.S. Treasury yield curve has steepened meaningfully over the past several weeks as long-term interest rates have increased relative to short-term rates.

Since the Federal Reserve’s (Fed) July 29th rate decision, where policymakers held the federal funds rate steady, short-dated U.S. Treasury yields have fallen slightly as traders reduced their expectations for imminent rate hikes. The front end of the yield curve is very sensitive to Fed rate policy. However, yields between 10- and 30-year maturities have continued to rise, particularly at the longest end of the curve where yields are 40 basis points higher (0.4%) in less than two months and flirting with their highest levels since 2007.

Some of this rise is attributable to inflation concerns related to the conflict with Iran and the closure of the Strait of Hormuz that is keeping energy prices high and volatile. Additionally, the U.S. economy continues to exhibit relative strength, which also typically contributes to higher yield environments. But the primary driver of higher long-dated yields has been rising term premia, which is the extra compensation global investors demand in the face of uncertainty.

On Wednesday, U.S. Treasury Secretary Scott Bessent announced that Treasury would “at least double” the amount of 10- to 30-year U.S. Treasury securities it would buy back via reverse auctions over the next two-and-a-half months. To fund this, Treasury will issue short-dated bonds and retire the longer-dated debt, thereby helping restructure the maturity mix of outstanding U.S. government bonds. While this will provide some support for previously issued longer-dated debt, the immediate effect is likely to be modest. What's more impactful is the signal sent by the announcement – the Treasury is monitoring the level of longer-term interest rates and is willing to assist with market liquidity and rising borrowing costs.

Short-term U.S. Treasury yields remain heavily influenced by expectations for Federal Reserve policy.

Although inflation remains above the Fed's target, policymakers continue to face a difficult balancing act. Economic activity has slowed from the exceptionally strong pace seen in recent years but remains supported by ongoing investment, particularly in technology and artificial intelligence. Labor market conditions have softened modestly but have not deteriorated significantly enough to warrant an aggressive easing cycle.

As a result, markets are increasingly viewing the current federal funds rate as appropriately restrictive. The bar for additional rate hikes appears somewhat high, but the case for imminent rate cuts is even more limited. This dynamic has helped keep short-term yields relatively contained compared with movements in longer maturities. 

The largest driver of rising long-dated yields has been the renewed focus on federal deficits and debt issuance. Large fiscal deficits require significant Treasury borrowing, increasing the amount of long-term debt that global investors are asked to absorb. At the same time, concerns surrounding long-run debt sustainability have encouraged investors to demand higher yields as compensation for holding longer-duration assets. This week, the total public debt outstanding crossed over $40 trillion. As the total amount of debt accumulates, so do total interest payments that the government must pay bondholders. Today, interest payments as a percentage of GDP sits near 3.1%, their highest level since the early 1990s. The Congressional Budget Office (CBO) has projected this to expand rapidly over the next decade, adding to the interest burden and potentially crowding out public spending.

Importantly, fiscal concerns affect long-term bonds far more than short-term securities. Even if Federal Reserve policy remains unchanged, growing debt supply and deficit concerns can place upward pressure on longer-term yields. For term premia to significantly recede, market participants would like to see progress towards a more balanced spending-revenue mix and a lower reliance on U.S. Treasury debt issuance.

Another factor supporting higher long-term rates is the market’s view that inflation risks remain elevated.

While inflation has moderated substantially from its peak, investors continue to face uncertainty surrounding energy prices, geopolitical developments, trade policy, and supply chain disruptions. These risks become more significant as the investment horizon extends, leading investors to demand additional compensation when purchasing longer-dated bonds. 

Economic resilience has also contributed to the rise in long-term rates. Despite periods of softer data, the U.S. economy continues to generate growth. Ongoing capital investment, especially in AI-related projects, combined with a still-healthy consumer sector, has reduced recession fears and diminished the urgency for lower long-term interest rates. 

At the heart of the recent move is a concept known as term premium. Term premium represents the additional compensation investors require for holding longer-maturity bonds instead of repeatedly investing in shorter-term securities. When uncertainty surrounding inflation, government borrowing, fiscal policy, or geopolitical risks rises, investors often demand a larger term premium.

We believe much of the recent steepening reflects a rebuilding of term premium rather than a fundamental change in expectations for near-term Federal Reserve policy. The market is increasingly signaling that investors require greater compensation to commit capital for ten, twenty, or thirty years. Since the June 24^th low, measures of the 30-year term premium have risen roughly 40 basis points (0.4%), virtually identical to the move in the 30-year U.S. Treasury yield over that span. A similar dynamic emerged in October 2023, that pushed U.S. Treasury yields sharply higher. At that time, the 10-year U.S. Treasury yield briefly touched 5%, which still holds as this cycle's high-water mark, before falling precipitously to close out that year. 

The recent increase in long-term yields presents both challenges and opportunities for fixed income investors.

In the near term, higher yields can create price volatility. However, for investors with longer time horizons, higher yields improve future income generation and increase expected returns. Today's yield environment offers significantly more income than investors have received during much of the past two decades.

We continue to favor high-quality fixed income and maintain a constructive view on duration. Elevated U.S. Treasury yields, attractive real yields, and tight credit spreads support the case for emphasizing high-quality bonds as a core source of portfolio income.

At the same time, tight credit spreads suggest investors are currently receiving more compensation for duration risk than for assuming significant credit risk. This reinforces our preference for maintaining an up-in-quality bias across fixed income portfolios. 

The recent steepening of the U.S. Treasury curve reflects a market increasingly focused on fiscal sustainability, robust government debt issuance, and inflation uncertainty rather than imminent changes in Federal Reserve policy. While these forces have pushed long-term yields higher, they have also improved the income and return potential available to fixed income investors. In our view, the resulting increase in yields continues to support a constructive outlook for high-quality fixed income and reinforces the importance of focusing on income generation, quality, and portfolio diversification.