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The bond sell-off is about more than just inflation
Key takeaways
- US 10-year yields surged almost 20 basis points this week and are up 100bps since late February, trading just below 5% and near their highest since 2007.
- The escalation in the Iran War has pushed Brent crude to US$108 per barrel and doubled European gas prices from their June lows, worsening the global inflation outlook.
- Central banks are responding: the ECB delivered its second hike of 2026 to a 2.50% deposit rate, and markets place around a 70% chance of a Fed hike next week.
- Investment demand from AI, the energy transition and defence is competing for a limited pool of global savings, pointing to a structurally higher real interest rate environment.
Global bonds are under pressure. US 10-year government bond yields surged almost 20 basis points this week, bringing their total increase since late February to 100bps. The key global benchmark is now trading just below 5% and within a whisker of the highest levels seen since 2007.
US 30-year government bond yields are already at a 19-year high of 5.36% and continue to rise despite efforts by US Treasury Secretary Bessent to cap the spike. To put this level in even more historical context, since August 2002 US 30-year government bonds have only closed their trading session above this level for a total of 34 days.
First driver: energy prices
What is behind the sell-off in global bond markets? In our view, there are three key drivers. First, the escalation in the Iran War this week has placed significant pressure on global energy prices. Brent crude oil futures have spiked to US$108 per barrel, the highest we’ve seen since May. European natural gas prices have surged even more, doubling from their June lows to the highest level we’ve seen since 2022. These higher energy prices are leading to a further deterioration in the global inflation outlook.
Second driver: central banks turn hawkish
Second, central banks are becoming increasingly concerned over this persistent, above-target inflation outlook. This is boosting market expectations of more aggressive monetary policy tightening over the coming six months, fuelled also by recent hawkish signals by Fed Chair Warsh. As we have noted in our benign, malign and malignant oil scenarios, the longer the war persists and the more permanent the lift in energy prices, the higher central banks will need to lift rates to ensure inflation expectations don’t become unanchored.
This week, we saw the ECB deliver its second interest rate hike of 2026, lifting the deposit rate to 2.50%. With the inflation outlook continuing to deteriorate, another rate hike is likely before the end of the year. In fact, the market is currently pricing in almost four more ECB rate hikes by mid-2027.
Next week, it will be the Fed’s turn. The Fed’s decision remains finely balanced and will be heavily influenced by tonight’s CPI release. However, as it currently stands, a rate hike is looking increasingly likely. The market is currently placing around a 70% chance of a rate hike next week, with around 3½ hikes priced by mid next year.
The market is currently placing around a 70% chance of a rate hike next week.
Third driver: a global investment boom
The third key reason behind the sell-off in bond yields this year is far more structural. Global interest rates are facing upward pressure from shifts in the balance between global investment and global savings. Investment requirements continue to accelerate, reflecting the rapid expansion of AI and data centres. Unlike last year, hyperscalers can no longer rely on their free cash flows to fund capex and are instead turning to bond markets.
AI is not the only driver of global investment requirements. Significant investment is also required to fund the energy transition, while governments are also committed to boosting their defence investments over the coming decade. This means increased competition for global savings to fund desired investment projects. Back in the mid-2000s, we were experiencing the opposite effect; what Fed Governor Bernanke declared at the time as the global savings glut. Global investment was low following the dot-com crash and an abundance of global savings was acting to put downward pressure on longer-term yields.
Where will the savings come from?
The shift to a global investment boom that we are now experiencing has significant implications. First, the savings need to come from somewhere. At this stage, there is little evidence that we’ll see more savings from the government sector (i.e. reduced borrowings/lower deficits). Consequently, the savings need to come from the private sector. To encourage the private sector to save rather than spend, we need to see a structurally higher real interest rate environment.
Households and businesses need to understand this regime change. A near-zero interest rate world is a distant memory, and a higher-for-longer interest rate world is here to stay. Consumption and savings patterns need to shift, while hurdle rates need to be increased to reflect the higher risk-free rates. Some previously viable projects may now need to be shelved if they no longer deliver adequate returns. The higher risk-free rate will also see investors increasingly attracted to assets with strong and secure cash flows over assets that generate returns through (riskier) capital gains.
A near-zero interest rate world is a distant memory, and a higher-for-longer interest rate world is here to stay.