Yields are soaring. Is inflation the cause? Not exactly.
By David Enna, Tipswatch.com
Treasury Secretary Scott Bessent, when criticized, often says the United States has the “best-performing bond market in the developed world.” As evidence, he points to successful Treasury auctions in recent months.
But then came the $70 billion auction of a 5-year Treasury note on September 23. The auction generated a shocking result: A nominal yield of 5.033%, up 64 basis points from the same auction in August; it was the highest yield for this term since June 2006. The bid-to-cover ratio was weak at 2.21.
That was followed by last week’s 7-year Treasury note auction with a similar result: A high yield of 5.085%, up 57 basis points from the August result.
This led to a troubling Wall Street Journal headline: “A Perfect Storm Is Raging in the Bond Market“.
From an intractable conflict in Iran to a seemingly indestructible U.S. economy, it just “doesn’t make sense to a lot of people to own bonds here,” said Christopher Sullivan, chief investment officer at the United Nations Federal Credit Union. … All in, it was the worst day in nearly 18 months for U.S. government bonds.
Ironically, this surge in longer-term Treasury yields comes a month after Bessent launched a repurchase effort to lower the Treasury’s costs of borrowing, a move that was poorly received by the bond market. Three weeks later, the Federal Reserve raised its key short-term interest rate by 25 basis points, more or less counteracting Bessent’s efforts.
From Bloomberg last week:
“It’s rare you get a move like this in bonds,” said Dave Aspell, co-chief investment officer at Mount Lucas Management LP. “The Fed has hiked again, inflation is clearly not at target. The economy is doing okay and there’s a large amount of government spending.”
Can we talk about U.S. debt?
In my opinion, today’s interest rates are where you would expect them to be in an environment of strong economic growth, excessive federal deficits, soaring corporate borrowing for an AI build-out, falling foreign demand for U.S. debt, and supply-shock inflation rolling across the nation.
Why is there such a great need for the Treasury to borrow? And at lower rates? Let’s take a look.
Through the 10 years of Trump-Biden-Trump presidencies, the U.S. debt has more than doubled to $40.2 trillion. The increase appears to be accelerating in the wake of Big Beautiful Bill tax cuts and massive spending dedicated to the war with Iran.
Obviously, higher deficits mean higher borrowing by the Treasury and that is coming at a time of higher interest rates. There you go … a perfect storm.
The Treasury is projecting that interest expenses for the U.S. government will increase to $1.27 trillion in fiscal 2026 (which ends this month) — and that was with 3.49% borrowing costs. Both the amount of borrowing and the interest costs will rise in fiscal 2027. The 4-week T-bill is now trading at 4.04% and is likely to go higher.
With the U.S. government expecting about $5.6 trillion in revenue for fiscal 2026, interest expense is now 23% of revenue.
Consider this: The U.S. deficit of $40 trillion caused $1.27 trillion in interest expense this fiscal year, which adds to the deficit. At 4.25%, interest on just that interest will cost well over $55 billion in fiscal 2027.
Foreign demand is slipping
After 20 months of bullying, insulting, and tariffing its strongest allies, the United States could be triggering a buyer’s strike among foreign central banks. This is a difficult premise to confirm, however.
There is some evidence of a buyer’s strike in the Treasury’s report titled “International Capital Data for June“. It shows that net foreign purchases of U.S. T-bills fell from $250.5 billion in the 12 months through June 2025 to just $49.4 billion in the 12 months through June 2026. Inflows to Treasury bonds and notes also fell from $561.1 billion to $329.3 in July 2026.
This is fairly strong evidence that foreign buyers, including central banks, aren’t as willing to pour money into U.S. Treasurys. It could be a side-effect of tariffs, because trade surpluses with the United States result in U.S. dollars that are often invested in the U.S. Treasury market.
The main point is that declining inflows of foreign investments in U.S. Treasurys — at a time of rising borrowing needs — cause demand to soften and yields to rise, as we have seen.
The inflation factor
I often hear financial commentators point to rising inflation expectations as a root cause of higher Treasury yields. Certainly, inflation is a factor, but not a primary factor. U.S. all-items inflation is currently running at 3.4%, above trends of the last two years because of the oil shock triggered by the Iran war. Take out food and energy and you get core inflation at 2.4%, the lowest rate in more than five years.
Real yields are rising, and so you might assume inflation has to be the reason. But it isn’t. In fact, I would argue that real yields are rising simply because nominal yields are rising. From Reuters last week:
Federal Reserve Bank of Cleveland President Beth Hammack said on Friday that surging bond yields are not being pushed up by inflation fears. When it comes to the jump in government bond yields, “it’s real rates that have moved up more than the inflation expectations,” Hammack said.
“We’re reasonably well anchored from an inflation expectations perspective” and rising bond yields reflect a solid economic outlook, competition for investor cash due to strong tech sector investment, as well as market participants adjusting prices to deal with the monetary policy outlook, the official said.
In this chart, notice the gap between the 10-year nominal yield, which is surging, and the 10-year real yield, which is also surging — at nearly the identical pace. The gap is the 10-year inflation breakeven rate, which is a measure of inflation expectations. Here is the breakeven trend for the same period:
This chart shows inflation expectations have been remarkably stable over the last four years. I consider this pattern highly unusual, and it shows that inflation is NOT the primary cause of elevated real and nominal yields. In fact, if inflation expectations were the key factor, real yields would be declining versus nominal yields, resulting in a higher inflation breakeven rate.
In essence, TIPS and nominal bonds are trading at equilibrium — yields for both are rising, indicating weaker demand for both at a time of higher borrowing needs.
Conclusion
“You can’t keep dumping duration into a market that doesn’t want it.”
That quote is from economist Freya Beamish in her excellent (and entertaining) team podcast, Perkins vs. Beamish. The latest episode is titled, “Buy the Bond Blow-Up?“
I’m going to say again that today’s elevated real and nominal Treasury yields reflect our current reality of a healthy U.S. economy, strong job market, surging borrowing needs, depressed foreign investments, and supply-shock energy prices that could begin spreading across the U.S. economy.
What changed in recent weeks? First, we got the Treasury secretary attempting a slippery run-around to lower longer-term yields (failed). Then the war with Iran expanded into a regional conflict, sending oil prices higher. And then the Federal Reserve raised interest rates, probably the first of several increases into next year.
Add to that about $400 billion in corporate borrowing in 2026 to fund the AI build-out. For the bond market, this is “the new normal.”
For what it’s worth, let’s end with a “more pain to come” video featuring Grace Peters, co-head of JP Morgan Private Banks’s Global Investment Strategy:
Also see: Secretary Bessent, take note: Treasury yields are not ‘too high’
And: Schwab analysts weigh in on bond-market disruptions
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. I Bonds and TIPS are not “get rich” investments; they are best used for capital preservation and inflation protection. They can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
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