Global bond yields saw a retreat on Thursday, providing a calm to the market after the Federal Reserve's rate hike and Chairman Kevin Warsh's pledge to control inflation. Yields on 10-year Treasuries decreased by three basis points to 4.99%, halting an eight-day increase. Similar declines were observed in Australia (three basis points) and Japan (less than one basis point) for similar-tenor notes. This follows a period where US Treasuries had largely maintained gains even after the Fed lifted interest rates for the first time since 2023, signaling further hikes to combat inflation.
However, James Bilson, a fixed income strategist at Schroders, views the recent surge in government bond yields as a reflection of an imbalance between demand and supply in the global economy, rather than a rise in sovereign credit risk. He highlights three market indicators that support this view: short-dated US Treasury yields rising faster than long-dated ones, Treasuries outperforming swaps and other government bonds, and a decrease in the cost of insuring against a US default. Bilson links robust private investment demand, particularly in large-scale AI infrastructure spending (expected to exceed $1.75 trillion in 2026 and 2027), and a boom in defense and energy-related capital expenditure, to global supply capacity constraints stemming from recent shocks, especially in the Middle East.
Bilson argues that the fundamental reason for the current weakness in bonds is that combined fiscal and monetary policy, particularly in the US, is too loose to sustainably achieve 2% inflation. He explains that if fiscal policy were to reduce demand, monetary policy would be sufficiently tight to meet inflation targets. However, since fiscal policy is not withdrawing demand, tighter monetary policy becomes the necessary "release valve." He suggests that genuine support for bonds would come from the Fed actively tightening policy, rather than just sounding tough on inflation. He anticipates that a limited "adjustment cycle" of two to three rate increases would be sufficient, given stable inflation expectations and contained wage growth.
While tighter short-term policy would increase yields on bonds maturing within five years, Bilson believes it could also support longer-dated debt by flattening the yield curve. He asserts that the primary threat to long-dated bonds is not tighter short-term policy but rather a Federal Reserve that appears indifferent to higher inflation. He considers a September rate hike to be a close call, but slightly more probable. Other potential solutions to the bond sell-off include a weakening of private investment demand, particularly in AI infrastructure, or tighter fiscal policy through spending cuts, tax increases, or a combination. Bilson dismisses US Treasury buybacks of longer-dated debt or a shift to more short-dated issuance as merely temporary fixes. He also deems a Fed move towards yield curve control as a "nuclear option" with a very low probability, arguing it would suppress long-end yields while increasing monetary growth and demand.
Despite the current challenges, current yield levels are seen as providing support for bond investors, offering a meaningful return after accounting for inflation. This contrasts with the past two decades when real returns were not always evident. The yield curve is also described as more supportive, with longer-dated bonds offering higher yields than shorter-dated ones, which should encourage demand for longer-term investments. Policymakers, particularly in the US, are reportedly becoming concerned about rising borrowing costs, as evidenced by the US Treasury's joint intervention with Japanese authorities to support the yen and its plans to increase buyback operations in long-dated bond markets to maintain liquidity. These actions, though small in scale, signal a readiness to intervene to manage yields.
