By Ryan Boyle

Moving up is usually how we describe a favorable life event, like a promotion or buying a house.  But when yields move up, there is less cause for celebration.  From the start of December to their recent peaks, 10-year yields have gained 68 basis points in the U.K., 60 basis points in the U.S., 55 basis points in Germany and 48 basis points in Canada.  Local factors are at play in each case, but they share common origins.

The sustainability of public finance is an ongoing concern.  As we have regularly discussed, demands for government spending are rising, but tax revenue is not keeping pace.  Inflation risk is ever-present and difficult to manage; bonds must compensate buyers for potential changes in purchasing power.  The uncertainty around inflation has contributed to a rising term premium, which investors demand in exchange for locking up capital for longer periods of time.

Persistent inflation is also reducing prospects of central bank easing, which feeds into the higher for longer story surrounding interest rates. Quantitative tightening has reduced central banks’ participation in bond markets, reducing quantity demanded from buyers who helped to keep yields low. A general reconsideration of neutral rates in the post-pandemic world has raised an additional uncertainty over the appropriate price of fixed-income securities.

Only the timing of recent surges comes as a surprise.  Bonds have been in a bear market since 2020, when yields reversed a downward trend that had lasted about 40 years.  Year-to-date volatility is consistent with the longer-run forces that have moved fixed income markets.

Domestic elements are also at play.   U.K. gilts are suffering from investor concerns around stubborn inflation and the sustainability of the tight fiscal headroom set forth in the Autumn Budget.   The risk of new U.S. tariffs has further clouded the outlook.

The U.S. tracked the U.K.’s rate movement, with an array of concerns leading to re-assessment of bond prices.  While budget proposals are still taking shape, the near-certainty of extending tax cuts will keep the nation’s deficit widening; prospects for government spending cuts remain abstract. The return of the debt ceiling raises the urgency of action this year. Meanwhile, firm inflation and generally favorable economic and employment data have caused markets to further price out the prospects of Federal Reserve rate cuts.

As yields rise, consequences accumulate across the economy.  More government revenue will need to be spent on debt service, crowding out other priorities and forestalling hopes for lower taxes.  U.S. Treasury debt is the risk-free benchmark by which many other debt instruments are priced; even if bond spreads remain well-contained, the cost of borrowing will rise for all issuers.  Corporations may face greater financing costs as their older debts mature, which will weigh on valuations.  Mortgage holders will continue to pay elevated amounts, an ongoing burden for most household budgets around the world. 

In the extreme, bond markets can alter policy.  The “bond vigilantes” of the 1990s expressed their discomfort with government spending by selling their holdings.  The pain of inflation was still a recent memory, and reflation was perceived as a significant risk.  Yields rose significantly: in 1994, the 1-year Treasury bill yield more than doubled from 3.5% in January to 7.2% in December.  Though painful, it did bring about change.  Leadership in Washington worked in a bipartisan manner to shift the nation’s fiscal trajectory, achieving a balanced budget at the decade’s end. 

A return of the vigilantes forcing policy shifts is not our base case.  However, the ever-present risks give us little reason to expect yields will fall by much.  The only thing moving up in the year ahead may be the blood pressure of bond traders.