Although people are deeply concerned about inflation caused by war, various signs indicate that other factors also have a significant impact on long-term borrowing costs.
In the United States, so-called real yields—adjusted for inflation—have had a greater impact, indicating that bond investors are concerned not only about price pressures stemming from a potential war with Iran.
Other culprits include signs that the already substantial public debt burden will further intensify, the negative impact of the artificial intelligence investment boom, and the growing likelihood that central banks such as the Federal Reserve will raise interest rates rather than lower them.
Strategists at ING, Goldman Sachs, and Barclays also emphasized this view that even if inflation driven by rising oil prices moderates, the recent surge in some long-term yields will not be fully reversed.
Even after the conflict ends, this could keep market borrowing costs near multi-year highs, continuing to put pressure on governments and economies worldwide.
Jonathan Hill, head of U.S. inflation strategy at Barclays, said: “The notion that global duration bonds have been sold off due to inflation concerns is difficult to reconcile with market pricing of medium- to long-term inflation risks. Instead, the real drivers behind rising real interest rates may be the interaction between increasing debt levels, potentially higher neutral interest rates, and artificial intelligence.”
The neutral interest rate refers to the level of interest rates that neither stimulates nor slows down the economy.
Although surging oil prices may have dominated the news headlines, the increase in breakeven inflation rates—used to gauge inflation expectations in bond markets—has been far less than the overall rise in interest rates in the United States and the United Kingdom.
Hill noted that even as the war continues, the U.S. 10-year breakeven inflation rate remains 50 basis points lower than during the Federal Reserve’s rate-hiking period in the first half of 2022. Meanwhile, the so-called 5-year breakeven rate—a market indicator of medium-term inflation expectations—remains roughly flat compared to last December’s level, at around 2.2%.
Claudio Irigoyen and Antonio Gabriel, economists at Bank of America, are closely monitoring changes in the yield curve to identify factors affecting the bond market. The yield curve refers to the gap between long-term and short-term interest rates.
They stated: “In an environment where the Federal Reserve may intervene and further widen the fiscal deficit amid rising debt servicing costs, the long-term interest rate curve has become more sensitive to interest rate changes that should primarily be driven by short-term rate movements.”
Patrick Gavney, head of Americas research at ING, said this transaction means that even if the Strait of Hormuz—the key global energy flow chokepoint—finally reopens after being shut down due to war, long-term interest rates “could find themselves lingering at high levels” due to persistently elevated real yields.
He believes that the 10-year U.S. Treasury yield breaking above 4.5% was entirely due to rising real yields. On Tuesday, the benchmark U.S. Treasury yield briefly approached 4.70%, before falling back to 4.56% on Friday.
“Reopening the Strait would dampen inflation expectations, but could keep real yields elevated; if so, Treasury yields would not decline as sharply as many currently expect,” said Gavi.
JPMorgan Chase CEO Jamie Dimon said last week in an interview with Bloomberg Television that U.S. interest rates could rise further due to concerns over government borrowing and debt demand.
Philip Lee, head of real money interest rate sales at Goldman Sachs, believes that persistent fiscal deficits, increased government bond issuance, and growing concerns about debt sustainability are increasingly explaining why investors demand additional compensation for holding long-term debt.
“I think interest rates will continue to rise,” he said in a podcast program at Goldman Sachs.
At the beginning of the year, traders bet that the Federal Reserve would cut interest rates, but now they believe that even with Kevin Warsh taking over as chairman, the Fed will have to raise rates this year.