Yields continue to return to a different time

Bond rout

The increase in long-term bond yields is attracting a lot of commentary, reflecting concerns that higher yields will become an issue for equity valuations. There are several factors at play. 

The current inflation risk flowing from higher energy prices threatens another more general inflationary wave and an even longer period of price rises being above central bank targets. 

That in turn means higher interest rates. Recent US inflation data appears to confirm these fears – annual consumer price inflation was 3.8% in April and producer price inflation was 6.0%.

Another concern is fiscal dominance. As government deficits and debts rise, debt interest payments become a source of financial instability which can impact a central bank’s ability to meet its inflation targeting mandate. 

Inflation risk premiums rise as a result. The condition of fiscal dominance necessarily means higher government borrowing and concerns over debt stability. These require higher long-term bond yields to compensate investors who hold bonds for the elevated risk. 

Genuine fundamental concerns

The inflation concern is very much present. So far, markets believe that central banks are committed to their inflation targets – even though they have not been able to meet them recently – and that short-term rates will be raised if necessary. 

A permanent increase in long-term yields would only occur if markets believed inflation targets were not credible or that central banks were not committed to them. There is no evidence for this yet. Long-term inflation expectations have risen a little recently but remain within long-term established ranges.

The fiscal concerns are also genuine; after all, governments are borrowing more. But there is little evidence of investors not being willing to buy newly issued debt. Even in the UK where there has been much concern about the government bond (gilt) market, recent auctions have gone well with demand remaining very high. 

However, government borrowing today is locking in higher yields. The 30-year US Treasury bond issued on 15 May came with a fixed coupon of 5%. 

There are important fundamental reasons why bond yields have continued to climb since their 2020 lows. Central banks have normalised interest rates. Inflation has been higher. Government debt levels were raised during the pandemic and in response to the 2022 energy shock. 

Fiscal policy is expansionary in the US. Defence spending is increasing everywhere and there is speculation that if the current energy shock persists, governments will again be forced to use fiscal policy to offset the negative impact on household income and business costs. 

Markets now demand yields like those in place before the global financial crisis. Just note, US inflation was 4% in 2007; 3% in Germany and 3% - on the way to 5% - in the UK. 

Normalisation

I have noted in the past that there is a relationship between nominal GDP growth and the level of long-term bond yields. Today’s bond yield levels are not out of line with that relationship and given the higher inflation rates of the last five years, nominal growth is certainly higher than it was in the decade after the global financial crisis. 

In a longer-term setting, what we continue to go through is a normalisation of bond yield levels (and interest rates) in the context of inflation risks being more to the upside than they were in the 2010s. 

When I first started in this role, the 30-year yield in the US was 4.5% and it went up to 5.4% in mid-2007. Then, it would have been crazy to think that in just over a decade’s time the yield would fall to 1.0%. It did. If one’s view of the bond market was conditioned when yields were that low, then 5% looks very high. But the world has changed, from deflationary globalisation to inflationary polarised fragmentation. We are in an era of higher bond yields.

Poor sentiment

There is also a sentiment issue. The fundamental factors above generate negative feelings. But there is a political aspect to it as well. Markets don’t currently have a lot of faith in incumbent governments. 

US President Donald Trump’s approval rating is low. The UK could see a challenge to the leadership of Sir Keir Starmer in the weeks ahead. In Japan, markets are still coming to terms with the economic programme of Prime Minister Sanae Takaichi, fearing it could lead to higher government deficits. 

Within Europe, the outlook for leadership in Spain, France and Germany is tinged with uncertainty. A difficult macro environment coupled with unpopular governments raises the risk that fiscal policy will be used to bolster electoral prospects. If credibility is a government asset, then any weakening undermines the value of government liabilities.

Take the UK

The UK is a good example. Following the recent local elections, a challenge to Prime Minister Starmer’s leadership is looking increasingly likely. The gilt market has underperformed its peers recently, with average spreads against the bonds of other G7 countries rising to multi-year highs. 

The market thinks that possible replacements for Starmer and Chancellor Rachel Reeves would signal a lurch to the left and a watering down of the fiscal rules. The favourite to succeed Starmer, Andy Burnham, has already had to publicly declare that he will stick to the current fiscal framework. 

Doubts will remain, however, until there is more clarity on whether the leadership will change and what that implies for policy over the remainder of the current parliament (to 2029).

Clarity please

Markets need a clear view of economic policy. Today, they also need to be convinced that those policies are focused on fiscal responsibility, given how close some countries are to a real debt problem. Otherwise, bond yields will rise further, weakening the fiscal position of governments and creating real issues for risky assets.

The gap between the implied earnings yield on equities and government bond yields has already fallen a lot, particularly in the US. Borrowing costs for corporates are also rising. Unchecked, rising deficits and bond yields will create severe financial instability only to be addressed by either central bank intervention in markets (see the UK, September 2022) or a huge fiscal tightening that would trigger a recession. 

The normalisation of bond yields has been hard for fixed income returns. Since the end of 2019, annualised total returns for representative all-maturity US, UK and German government bond indices have been 0.14%, -3.8% and -2.5% respectively. Longer-duration sectors have fared much worse. 

Is that normalisation over? Right now, things look bad given rising inflation, nervous central banks, and an uncertain growth and fiscal outlook. However, developed market governments don’t default. 

Investors looking for income are in the best place they have been for years. Credit is resilient, and the additional credit spread is attractive. I don’t get the excessive bearishness on bonds. The equivalent would be to still be trying to short the equity market after a 25% correction. The bad news is largely in the price. 

However, the risk is clearly that current bond holdings will continue to be re-priced by further yield increases if concerns about inflation and the fiscal outlook worsen. Real yields are not quite back to their pre-2008 levels. The upside for bond investors is that any positive surprises – the war ends, energy prices come down, there is renewed policy commitment to fiscal stability – could generate a partial reversal of recent moves in long-term yields and keep central banks at bay.

Trading bonds is always challenging. But investors with a medium-term view should look at where yields are today as being the best potential guide as to what total returns could possibly be over the medium term, with almost all that return coming from income - from a buy and hold perspective. And maybe more than just yield if active investment strategies are pursued.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, BNP Paribas AM, as of 21 May 2026, unless otherwise stated). Past performance should not be seen as a guide to future returns.