What’s Driving Bond Yields?

What’s driving bond yields higher?

Is it the war with Iran, rising crude oil and diesel prices, fertilizer shortages, tariffs, expanding government deficits, semiconductor shortages, or increased AI borrowing?

All of the above expand demand for credit, reflected in rising nominal GDP growth, which competes for a limited supply of available credit.

Credit Supply

Credit supply isn’t growing at the same rate.

Foreign investment in US Treasuries has slowed. Japan and China have both shed more than $100 billion in the 6 months to August.

Total foreign holdings of US Treasuries fell by $155 billion over the last 6 months.

Increased holdings by the United Kingdom, Canada, Belgium, Luxembourg, and the Cayman Islands partly offset declines in Japanese and Chinese Treasury holdings. However, only Canada has a trade surplus with the US. Most of the balance reflects custodial accounts in major financial centers used by sovereign wealth funds, multinational companies, insurance companies, pension funds, and hedge funds engaged in highly leveraged Treasury market trades.

Norway’s $2.3 trillion sovereign wealth fund, the world’s largest, has also proposed significant cuts to its government bond holdings. US Treasuries are its largest bond holding, and will be cut by $80 billion to $135 billion in 2027, according to the proposal by fund manager Norges Bank. An increased allocation to non-government bonds would partly offset the decline, but overall exposure to the Dollar would fall.

In addition, Europe’s largest pension fund, the Dutch ABP, cut exposure to US Treasuries in the first quarter. (Reuters)

Bank credit growth is also slowing. The quarterly increase in loans, leases, and securities held by banks fell from $400 billion in Q1 to $200 billion in Q3.

Aggregate Demand

Activity, reflected by nominal GDP, is expected to accelerate in Q3.

The GDP price deflator jumped to 4.0% in Q2 of 2026.

The sharp increase reflects a 1.5% rise in Q2.

We expect at least a similar Q3 increase of at least 1.5%, taking the annual GDP deflator to 4.6% or more.

The Atlanta Fed GDPNow model projects that real GDP will grow at an annual rate of 3.6% in Q3.

That would increase annual growth to 2.1% over the four quarters, with nominal GDP rising to 6.7% or more.

Conclusion

If the Fed, under new Chair Kevin Warsh, lets market forces set interest rates, we expect the 10-year Treasury yield to rise above nominal GDP growth, which we expect to reach 6.7% in Q3 of 2026. That is the typical monetary policy path prior to 2000, before lax policy measures set the US on the path to the current debt-inflation standoff.

If the Fed changes tack and intervenes in the Treasury market by buying Treasury securities to suppress long bond yields, it will restore the imbalance and allow inflationary pressures to build.

In the first scenario, as the 10-year yield rises further, we expect demand to contract, stocks to fall, and the economy to go into recession. That would cause long-term yields to fall as nominal GDP growth slows. A new, more stable balance would then improve long-term growth.

In the second scenario,  the Fed introduces further QE, suppressing the 10-year yield as the supply of available bonds shrinks. Nominal GDP growth would accelerate as the gap widens, driving inflation higher. Stocks and Gold would rise until the Fed is forced to tighten monetary policy to curb inflation. This second path is unsustainable and would lead to higher volatility and more extreme boom-bust swings while long-term growth suffers.

Acknowledgments

• Federal Reserve of St. Louis: FRED Data
• CBO: The Budget and Economic Outlook, 2026 to 2036
• Reuters: Norway’s $2 trillion sovereign fund proposes deep cuts to US Treasury holdings
• US Treasury: TIC Data – Major Foreign Holders of US Treasuries