Reality Catches up to the Bond Market

Bond yields soared on Friday with the !0-Year U.S. Treasury yield rising 14 bps to 4.6%. Meantime the yield on the 30-Year Treasury hit 5.12%, its highest since 2007. Globally it was the same story, as Japanese yields are at their highest level since 1997 and government disarray in the U.K. is sending yields soaring there.

What’s going on? Three critical factors are coming together: rising inflation, government deficits, and an AI capital spending boom. Triggered by soaring oil prices caused by the Iran War, the U.S. consumer price index (CPI) is now 3.8% over year ago levels, and the producer price index (PPI) is now 6% over the same period a year ago. To be sure, core inflation at the CPI level is lower at 2.8%, but the core PPI is now running at a high 5.2% rate. More concerning is the likelihood that over the near-term, inflation will move higher, not lower. This clearly is not an environment for rate cuts.

Second, huge fiscal deficits are the order of the day. The U.S. continues to run a $2 trillion deficits around 7% of GDP, and with tariff refunds and higher defense spending it will go higher. Although the rest of the G-7 is doing much better, ex-U.S. the G-7 is running a deficit of 2.4% of GDP.

Last, the AI boom in the U.S. is sucking capital in from all over the world. Witness Alphabet’s recent $60 billion global offering. Here are the AI companies that used to supply capital to the rest of the world; they are now massive users of capital. Hence real rates have to increase and in the short run the massive expansion of data centers will put upward pressure on the price of inputs, ranging from memory chips to electrical equipment and construction labor.

 

This is the environment that incoming Fed Chair Kevin Walsh is facing. It is hardly an environment to cut rates. Indeed, with the two-year note now yielding 4.08%, well above the current midpoint of the Federal Funds rate of 3.63%, the market is now pricing in a rate hike. Those who say that Warsh will follow Trump’s orders to cut rates will soon be disabused of that notion. Kevin Warsh does not want to be remembered as the Fed chairman who looked inflation in the eye and blinked.

 

Finally, it is important to recognize that the recent rise rate is taking place in the context of a structural bond bear market. (See: https://shulmaven.blogspot.com/2025/01/we-are-in-early-stages-of-bond-bear.html ) Bond bear markets, just like bond bull markets last a long time. The last bond bear market lasted 35 years, from 1946 – 1981. We are now only in the sixth year of the bond bear market that began in 2020, when the 10-Year U.S. Treasury Bond bottomed at 0.56% in August of that year. So, buckle up, we are still early in a very long cycle.