"Even After War Ends and Oil Prices Fall, 10-Year U.S. Treasury Yields May Not Decline"

No Change in Expected Inflation

Rising Nominal (Bond) Yields

Indicates an Increase in Real Interest Rates

Focus on Structural Changes Such as Fiscal Deficit and AI

There is an analysis suggesting that even if the Iran war ends and international oil prices stabilize, interest rates may not decrease easily. This is because the market is reflecting structural factors—such as the United States' fiscal burden, the artificial intelligence (AI) investment boom, and the potential rise in the neutral rate—more sensitively in long-term interest rates than inflation concerns.

No Change in Expected Inflation...Bond Yields Rise as Real Yield Increases

According to Bloomberg News on the 25th (local time), the recent rise in U.S. Treasury yields has been driven more by an increase in the real yield than by changes in breakeven inflation (BEI). The real yield refers to the nominal interest rate minus expected inflation.

For example, if the 10-year U.S. Treasury yield is 4.6% and the market's expected average inflation rate (BEI) is 2.2%, the remaining 2.4% represents the real yield. In simple terms, this is the actual rate investors receive after stripping out inflation.

Usually, the market interprets a surge in international oil prices due to war as an inflationary threat, which leads to a rise in Treasury yields. Conversely, the general interpretation is that when a war ends and oil prices fall, interest rates are also likely to stabilize.

However, the situation is different this time. Bloomberg pointed out that the U.S. 10-year breakeven inflation rate, which indicates expected inflation in the bond market, is still 50 basis points (1bp=0.01 percentage point) lower than it was in the first half of 2022, when the Fed was aggressively raising rates. The '5-year, 5-year forward breakeven inflation rate (5y5y BEI)', a measure of medium-term expected inflation, is also around 2.2%, showing little change from the end of last year.

Expected inflation has not changed significantly, yet long-term bond yields have surged. This suggests that the market is focusing more on structural changes in the U.S. economy than on concerns that prices will rise due to oil, tariffs, or wages.

Jonathan Hill, Head of U.S. Inflation Strategy at Barclays, analyzed, "The explanation that the sell-off in long-term bonds is simply due to inflation concerns does not align with market pricing," adding, "An increase in government debt, the possibility of a higher neutral rate, and expanded AI investment may be driving up real yields."

In other words, the market is beginning to see that the structure of the U.S. economy requires tolerating higher interest rates than in the past—in short, the "cost of money" itself needs to become more expensive.

Fiscal Deficit, AI, and the Prospect of a Higher Neutral Rate...Structural Changes in the U.S. Economy

In the market, the expansion of the U.S. fiscal deficit is also identified as one of the main reasons for the rise in long-term interest rates. With President Donald Trump's push for tax cuts, there is a heightened possibility that the already large national debt will grow even further, and as a result, the volume of Treasury issuance is also expected to increase.

The AI investment boom is another variable. While AI has the potential to lower prices over the long term by raising productivity, Bloomberg reported concerns that, in the short term, it could instead fuel economic overheating and upward pressure on prices through a surge in demand for semiconductors, large-scale investments in data centers, and increased corporate bond issuance by technology companies.

There is also speculation in the market that the neutral rate—the rate that neither stimulates nor slows down the U.S. economy—may be higher than in the past. Hill, the Barclays strategist, said, "A 5% yield on 10-year U.S. Treasuries may no longer be considered cheap," adding, "This could justify higher yields."

A higher neutral rate means the U.S. economy has shifted to a structure that can withstand higher interest rates than before. Until now, the market expected the Fed's long-term benchmark rate to be around 2–3%, but if the neutral rate rises, a higher interest rate could become the new "normal." In the past, a 5% yield on the 10-year Treasury would have been seen as an attractive investment, but that may no longer be the case.

This also means that the environment could persist in which it is difficult for the Fed to cut rates easily. Indeed, as recently as the beginning of the year, the market had expected the Fed to lower interest rates this year, but recently, it has even begun to factor in the possibility of rate hikes.

Padraig Garvey, Head of Americas Research at ING, said, "Even if the Strait of Hormuz reopens and expected inflation stabilizes, if real yields remain high, U.S. Treasury yields may not decline as much as the market expects."

This content was produced with the assistance of AI translation services.