Why have long-term interest rates risen?

The previous blog shows how market expectations of likely cuts in short-term interest rates have been evolving. Those changes will have had some influence on longer-dated yields too. Recently, however, even as policy rates continue to trend lower, some of the longest-maturity US and UK yields have touched multi-year highs. What’s going on?

Three distinct drivers may be at work, separately or together. An altered outlook for longer-term inflation and growth (perceived changes in “fundamentals”); a rethink on debt and borrowing (“creditworthiness”); forced sales by distressed investors (“technical”). Each one has merit.

The “fundamental” explanation is not as implausible as it sounds. A lengthy trade war would drive expected nominal growth down, not up; but then in recent weeks such an event has seemed less, not more, likely than it did immediately after “Liberation Day” on 2 April. And if the globally-integrated business model remains broadly intact, against a backdrop of fiscal expansion and low unemployment, then more inflation risk, and some increase in the expected real policy rates needed to contain it, makes sense. This possibility featured in our pre-Liberation Day worldview after all.

“Creditworthiness” is certainly a talking point of late, as government debt ratios are either rising further (notably in the US, but also – from a much healthier starting point – in Germany too) or staying elevated for longer. And just as President Trump’s “big, beautiful bill” makes its tax-cutting way through Congress, and import duties seem set to fall short of expectations, leaving the prospective fiscal deficit heading towards 7%, the US has indeed lost its remaining AAA sovereign debt rating. Is this (finally) the level of debt at which investors worry about default, and demand higher yields? Are the fabled “bond vigilantes” riding again?

The ”technical” explanation is backed by reports of fire sales by leveraged bond investors. Hedge funds do often seem able to find new, complicated ways of losing money (as per recent “basis trades” perhaps), and we have wondered whether regulators have a blind spot for leverage here. Meanwhile, recent heavy central bank buying and selling, and liability-matching at life and pension funds, may have made longer-dated bonds especially illiquid, and vulnerable to lumpy trading. The recent widening of the gap between US 30-year and 10-year yields, while that between 10-year and 2-year yields has narrowed, does seem to shout “technical”.

Each explanation has its flaws. Why should inflation risk be suddenly prominent beyond the 10-year plus area? Ditto credit risk. And why are there so few signs of any threshold effects historically (the Truss “moron premium” was, as we noted at the time, not quite what it seemed)? How widespread are those basis trades and investor distress?

We don’t have to decide definitively. Our inclination currently is to give “creditworthiness” a bit less weight than the other two explanations. This may matter, perhaps, because if we felt that government debt levels had to fall significantly before we could advise owning more longer-term bonds again, we could be waiting a long time.

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