10-year U.S. Treasury yield breaks above 5% to nearly a 20-year high, Fed's anti-inflation credibility faces major test

According to Zhitong Finance APP, the yield on the U.S. 10-year Treasury note has risen to its highest level in nearly 20 years, marking the latest milestone in the global bond sell-off. This round of sell-off has been driven by surging energy prices, rising debt levels, and inflationary pressures.

The “anchor of global asset pricing” breaks 5%, raising a major test for the Federal Reserve’s credibility in fighting inflation

On Tuesday, the 10-year U.S. Treasury yield, known as the “anchor of global asset pricing,” rose by 4 basis points to 5.02%, surpassing the peak set in 2023 and reaching its highest level since 2007. The latest surge in yields followed a rise in global oil prices, as risks to Middle East oil supply are mounting.

The pressure in the bond market has heightened tensions ahead of the Federal Reserve’s interest rate decision on Wednesday. Investors expect Fed officials to raise short-term borrowing costs for the first time since July 2023. If the Fed does not hike rates, or if Fed Chair Kevin Walsh signals less monetary tightening in the coming months than the markets are currently pricing in, bond investors may demand higher yields to hedge against inflation risks.

Will Hartman, strategist at BMO Capital Markets, commented: “If the Federal Reserve keeps rates unchanged this week, it is very likely to undermine its credibility in fighting inflation. The markets are not only susceptible to the shock of an unexpected pause, but also to the impact of a ‘dovish hike’—that is, if the dot plot or press conference delivers a more patient tone.”

Dalip Singh, Chief Global Economist at PGIM Credit, said: “The more the Fed can demonstrate its anti-inflation credibility, the more likely it can compress the risk premium at the long end of the Treasury curve over the medium term.”

The yield on U.S. Treasuries is especially important because it serves as a pricing benchmark for other types of loans. In the stock market, it is also used as a discount rate to measure the present value of expected profits over the next several years. The higher the yield, the smaller the present value of future earnings. In addition, high bond yields may prompt funds to flow out of equities, as higher returns attract investors toward bonds.

Middle East conflict, AI bond issuance, and deficits intertwine, keeping pressure on the bond market sell-off

Since late February, when the U.S. launched military action against Iran disrupting oil and gas supplies in the Middle East, global bond yields have continued to climb. In addition, companies borrowing heavily to fund AI spending is also a factor, both swelling market debt and stimulating an already resilient U.S. economy.

The rise in yields has been particularly tricky for the Trump administration, as it has triggered chain reactions in the market, pushing up costs for mortgages and other loans ahead of the midterm elections in November. Earlier this month, President Trump threatened to cut off all U.S. trade with several countries if the Federal Reserve did not cut rates. This move would almost certainly intensify the sell-off in bonds by stoking inflation fears. Treasury Secretary Scott Besant has tried to rein in rising yields by increasing Treasury’s debt buybacks, but such operations have not proven effective.

Meanwhile, the scale of debt issued by governments worldwide continues to rise, both for refinancing maturing bonds and plugging fiscal deficits. At the same time, major central banks have stopped buying government bonds in large quantities via quantitative easing, and the demand from other traditional buyers has also cooled, making the market more reliant on price-sensitive investors.

Phoebe White, Head of U.S. Rates Strategy at UBS, remarked: “Given that we do not see any signs of weakness in the real economy, and the supply-demand dynamics in the U.S. Treasury market are very different from 2007, there is limited room for long-term yields to fall. The structural demand for U.S. Treasuries, especially from foreign official investors, has weakened significantly.”

A team of strategists led by Jay Barry at JPMorgan commented that they expect a possible rate hike this week, but since traders could react to the Fed’s statement and Walsh’s press conference, they remain “bearish” on long-dated U.S. Treasuries. Others are also cautious, believing that if the Fed surprises investors, the sell-off could resume.

Ed Al-Hussainy, portfolio manager at Columbia Threadneedle, said: “If the Fed does not hike rates, the long-end sell-off may become even more disorderly.”