The 10-year Treasury yield just crossed 5% for the first time since 2007, and the deficit is getting the blame. Scroll through the headlines and the story is the same: Washington has finally borrowed too much, and the bond market is making it pay.
We’re not convinced that’s the entire story. Yields are climbing across most of the developed world, and the bigger forces behind the move are oil, a hot economy, a wave of new corporate and sovereign debt, and a Fed that just started raising rates again. Bond prices have taken a hit along the way, but with yields this high, it might be a good time to rebalance into bonds.
Oil, a hot economy, and a flood of new bonds
Conflicts around the Strait of Hormuz, the Bab al-Mandab Strait, and between Russia and Ukraine have all pushed oil prices higher. Oil is an input into fuel, plastics, fertilizer, and nearly everything else. When it gets more expensive, costs rise at the gas pump, in airfares, in heating bills, and across the rest of the economy.
Take diesel: it just hit an all-time high of more than $6.50 a gallon, topping the 2022 record of $5.82. Diesel flows into the cost of nearly everything that gets shipped. For example, almonds grown in California’s Central Valley pass through a complex network of diesel-powered vehicles on their way to a grocery store shelf in New Jersey. The harvester, the trucks, and the freight trains all run on diesel, and every leg of that trip just got more expensive. Multiply that across the economy, and it shows up as inflation. Bond investors want a higher yield to stay ahead of inflation, and the Fed raises rates to bring it back down.
The economy is also running hot. Unemployment is low, consumers are still spending, and companies are putting record amounts into capital projects. That much demand makes it hard for inflation to come down and gives the Fed little reason to cut.
Supply matters too. The U.S. Treasury is issuing more debt to fund large deficits, and governments worldwide are doing the same. On top of that, the data center buildout has produced nearly $500 billion in new debt, most of it highly rated. All of those bonds compete for the same buyers, and yields have had to rise to attract them.
Rates are rising everywhere
Yields in Europe, the U.K., and Japan have climbed along with ours. This widespread move suggests the forces pushing rates higher are global and go beyond the U.S. deficit.
Japan stands out. For years, investors borrowed in yen at near-zero rates, converted that money into dollars, and bought U.S. Treasuries that paid much more. It’s called the carry trade, and it paid off as long as Japanese rates stayed low.
That’s changed. The Bank of Japan has been raising rates, and Japan’s 10-year yield has climbed from about 0.2% in early 2022 to more than 3% today, the highest since 1996. That has shrunk the gap with Treasuries to about 2 percentage points. As investors slowly unwind the carry trade, demand for Treasuries falls, pushing rates higher. Unwinding also means buying back yen, which strengthens the currency and makes the trade even less attractive for anyone still in it.
Where the Fed goes from here
The Fed raised rates on September 16, its first hike since 2023, and signaled one more before year-end. The market is also pricing in one to two more hikes in 2027. We think that could change. If inflation cools and oil prices come down as the conflicts driving them stabilize, the Fed may not need to go that far.
A silver lining of the Federal Reserve raising rates under its new Chairman, Kevin Warsh, is that it has given the market confidence in its commitment to its inflation goals. Short-term inflation expectations have risen, while long-term expectations have held steady. The September vote was unanimous, easing earlier worries about the Fed’s independence. A Fed the market believes in is less likely to let rates run away, and that’s good for bondholders.
Higher yields also bring in new buyers. Pension funds, insurance companies, and income-focused investors get more eager to lock in rates at these levels. That demand can help slow the rise over time.
Why it might be a good time to rebalance into bonds
Over the long run, a 10-year yield above 5% is normal. The 10-year averaged 6.67% in the 1990s and peaked near 16% in 1981. The very low rates of the 2010s were the exception.
Stocks have had a strong run, and many portfolios have drifted toward equities as a result. That makes this a reasonable time to rebalance back toward bonds, and doing so doesn’t require reaching for long-term bonds. The 2-year Treasury yields about 4.9%, the 3-year is at 5%, and the 5-year is just above it. Shorter maturities also carry much less duration risk, which is the price swing longer-term bonds take when rates move.
The starting yield on a bond portfolio has historically been a good guide to what it earns over the next several years, so today’s higher yields are good news for bond investors. Higher yields also give bonds more room to rise in price when rates fall. Rates often fall when stocks sell off, so bonds are better positioned to cushion a portfolio than they were a few years ago, when yields were much lower.
Corporate borrowers are in good shape for now. Defaults are low, and credit spreads, the extra yield investors get for lending to companies rather than the government, are near historic lows. That tells us the market isn’t worried about stress today. Conversely, tight spreads leave little room for error, and they’ve been tight before past downturns.
What this means
Rates are higher for reasons that are easy to trace. Oil prices are up, the economy is running hot, the U.S. and other governments are borrowing heavily, companies are issuing a lot of new debt, the yen carry trade is slowly unwinding, and the Fed has started raising rates again.
Some of that pressure is likely to stick around. The Fed has signaled another hike this year, and the conflicts pushing oil higher don’t have a clear end. Bond prices could stay volatile for a while.
The upside of lower bond prices is higher yields. Short-term Treasuries now pay close to 5%, and the 10-year is at its highest level since 2007. As bonds in a portfolio mature, that money can be reinvested at these higher rates. For portfolios that have drifted toward stocks, it might also be a good time to rebalance back into bonds.
