Why high yields on government bonds are causing alarm

Rising fiscal deficits and persistent inflation are fueling a decline in demand for long-term sovereign debt across the globe. Consequently, bond yields have been climbing to record highs. In Japan, 30-year government bonds are trading at their highest yield since 2000, while the UK's 30-year bond yields have reached their peak since 1998.

The average yield on government debt across the G7 nations is also at its highest level since September 2000. This exodus from long-term sovereign debt can be attributed to a combination of factors, including large fiscal deficits and inflation that remains stubborn. Governments are now competing with technology firms for investor attention as the latter issue vast amounts of debt to fund artificial intelligence infrastructure projects.

In response to the surge in US bond yields, which hit a near two-decade high, the US Treasury Department announced plans to buy back long-dated debt in August. The measure temporarily stabilized bond markets; however, yields have since continued to rise. Bonds issued by developed economies are considered the safest investments globally due to the low probability of default.

Nevertheless, investors must be aware that these bonds are not risk-free. If inflation or short-term interest rates climb, the real value of coupon payments and the principal repayment at maturity will be diminished. The longer the bond's maturity, the more susceptible it is to interest rate and inflation risks.

In mid-August, yields on 30-year US Treasuries surged to their highest level since 2007, although they have since eased slightly to 5.27 percent. German bonds reached their highest levels in a decade around the same time. The sell-off in long-term US Treasuries intensified in July following the Federal Reserve's decision to keep interest rates steady and Fed Chair Kevin Warsh's comments, which raised questions about his commitment to bringing inflation back to the Fed's 2 percent target after five years of failure.

Warsh's more aggressive stance on inflation, expressed in a speech during the Jackson Hole conference in late August, contributed to a steepening of the yield curve, as the gap between short-term and long-term rates widened. This trend is not exclusive to the United States. Japan's central bank has been cautious about raising interest rates, which remain among the lowest among developed nations.

The steepest yield curve among major bond markets currently exists in Japan, partly due to Prime Minister Sanae Takaichi's reluctance to let rates rise too sharply, fearing a setback to the economic recovery.

The bond market is also grappling with a structural shift in supply and demand. Over the past two decades, abundant global savings – particularly in Asia – have fueled a demand for safe assets, which helped keep long-term yields low. Former Federal Reserve Chair Alan Greenspan referred to persistently low long-term yields as a "conundrum," as rates remained low despite the Fed raising short-term borrowing costs.

Currently, governments worldwide are increasing spending on sectors such as renewable energy and defense. The US national debt has reached nearly $40 trillion, and the Congressional Budget Office projects an annual fiscal shortfall of $2.1 trillion. As governments borrow more, the supply of government bonds has expanded, while demand has waned due to weakened foreign interest and central banks reducing their holdings after years of purchases.

European Central Bank Executive Board member Isabel Schnabel describes this as a shift from a "savings glut" to a "bond glut."

The transition has resulted in a more price-sensitive private investor base, which typically demands higher compensation for holding long-term bonds. Additionally, structural changes in pensions and retirement systems have reduced the traditional long-term buyer pool. In the US, the term premium—the additional yield investors require for holding long-term debt—has risen by over 3 percentage points from its pandemic lows, according to a Bloomberg Economics model.

Historically, the US has enjoyed a "convenience yield," as investors paid higher prices and accepted lower payouts due to Treasuries' low risk, liquidity, safety, and usefulness as collateral. However, some argue that this advantage has diminished, citing the growing national debt load and President Trump's unpredictable policy-making.

A disorderly sell-off in the bond market could pose significant challenges for governments relying on debt markets to finance their deficits—a situation the UK experienced after former Prime Minister Liz Truss's resignation in 2022. The bond market has "taken out more governments than howitzers," according to US Treasury Secretary Scott Bessent. Long bond yields influence interest rates on various consumer loans and corporate debt.