Houston, we have a problem

But why have yields been rising? We think they are more a symptom of underlying issues, rather than the end problem itself. There are a few potential reasons:

• Weak public finances. The US government is running a record peace time deficit and the only thing that Republicans and Democrats can seem to agree on is spending more money. Thus. the prospects are for ever increasing amounts of government debt, making the US a more-risky proposition as a borrower (not that they are likely to default, rather that they are more likely to be tolerant of higher inflation to inflate their way out of a potential debt trap).
• External inflation concerns. From 2009 to 2021, inflation was hard to generate, and generally came through at or below the Federal Reserve’s 2% target. However, following COVID, that has reversed, with inflation remaining stubbornly high, comfortably above 2%. There are reasons to believe this regime change might continue, due to ongoing Middle East tension leading to high commodity prices, as well a trend of deglobalisation driven by geopolitics and a desire to focus on supply chain resilience rather than cost. Structurally high inflation would make fixed coupon nominal bonds less attractive.
• New Federal Reserve Chair. In May of this year, Kevin Warsh replaced Jerome Powell as Federal Reserve chair. One of his first acts was to remove “forward guidance” from the regular Fed communications framework, stating that it “was not well suited to the current policy conjuncture”. While this may or may not turn out to be a good thing, the short-term impact is that markets have less sense of the Fed’s direction of travel, and particularly their conviction on reducing inflation. This increased uncertainty has resulted in investors looking for higher yields as extra compensation.
• Other investment opportunities. As has been well documented, AI hyperscalers are spending many $ billions building out their offerings, and are financing a large chunk of this expenditure by borrowing money from the bond market. In effect they are now competing with the US government to borrow from long term bond investors. There is only so much cash to go around, so it feels like a bit of a buyers’ market at this stage.
• Fewer buyers? Over recent years, foreign reserves have been gradually diversified away from US Treasuries, with gold being a beneficiary. At the same time, the aftermath of the Iran invasion will likely mean a new wave of infrastructure investing, either to repair capacity in the Middle East or to build storage capacity elsewhere – both of which will require large quantities of cash that may otherwise have been parked in US Treasuries.