"No Room for Error": 3 Risks That Could Drive Bond Yields Even Higher

The yield on 30-year U.S. Treasury bonds briefly rose above 5.33% on Tuesday, August 18—reaching its highest level since 2002, according to CNBC. Some strategists expect the sell-off to continue.

After surveying market analysts, the network identified three key factors that could drive yields on long-term bonds even higher.

Bonds have found themselves at the center of concerns about everything from geopolitical instability—which is driving up prices—to debt-fueled artificial intelligence hype, Bloomberg notes. The market is essentially saying: “We expect higher inflation or, at the very least, greater uncertainty in the future, so we’re demanding higher yields on long-term bonds,” explains Justin Onuekwusi of St James’s Place.

At the same time, yields jumped despite weak macroeconomic data: retail sales are falling, and the labor market is cooling. Under normal circumstances, this would have increased interest in long-term bonds, but this time it may, on the contrary, have heightened investors’ concerns about these securities, according to Peter Shaffrick, global macro strategist at RBC Capital Markets, as quoted by the Financial Times. The economic slowdown, coupled with a massive budget deficit, raises questions about the sustainability of U.S. public finances, he explained. The rise in the cost of long-term borrowing is “a story that has been unfolding for years, and it is not over yet,” the strategist believes.

The sell-off in Treasury bonds wasn’t solely due to the situation in the U.S. Fundstrat strategist Mark Newton pointed to Japan, where economic growth came in weaker than expected, while inflation was high. “Yields on 10-year and 20-year Japanese government bonds rose, and this spilled over into U.S. markets, pushing long-term bonds to new multi-year highs,” he noted.

If yields in other major developed-market economies continue to rise, investors may demand a higher premium for holding U.S. government debt, according to analysts surveyed by CNBC.

BMO strategists also cited fiscal challenges in the U.S., Japan, the U.K., and Europe as one of the possible factors behind the weakness in long-term bonds. According to them, even if the U.S. economy weakens, the global revaluation of long-term debt could continue to put pressure on Treasury yields.

Despite signs of weakness in the U.S. economy, it may prove too resilient for interest rates to be cut significantly, according to CNBC.

Markets are currently pricing in an exceptionally favorable combination: steady growth and record-high prices, while further tightening by the Fed is expected to be limited and commodity shocks are expected to remain localized, according to a Deutsche Bank note cited by the TV channel. However, the bank warns that such an idyll will be difficult to sustain in the long term.

"By definition, strong economic growth and rising prices for risky assets mean that financial conditions will remain accommodative. This will boost demand and push central banks to raise rates more quickly,” warned Deutsche Bank macro strategist Henry Allen.

He noted that inflation in the U.S. remains above the Federal Reserve’s target level. When the Consumer Price Index (CPI) stands at over 3%, the central bank has historically raised rates by more than 100 basis points during the first year of a tightening cycle, according to Deutsche Bank.

This risk is specific to long-term bonds: investors may demand higher compensation for lending to the U.S. government for decades to come.

One reason is the massive volume of new borrowing amid less-than-robust demand. BMO noted that the latest auction of 30-year bonds closed with the highest yield since 2001, while five of the previous seven auctions of 20-year bonds showed weak results.

Inflation could exacerbate this pressure. According to BMO, the situation in the energy market remains a potential negative trigger for Treasury bonds, especially since their yields show virtually no sign of declining, despite weak macroeconomic data.

A new commodity shock would complicate the picture even further. As Deutsche Bank warned, a simultaneous slowdown in economic growth and an adverse inflation shock could lead to a synchronized collapse in the stock and bond markets. “Current market pricing leaves almost no room for error,” the bank’s strategists warned.

This article was AI-translated and verified by a human editor