(Bloomberg) - Long term interest rates in the U.S. have been heading higher. Yields on 10-year Treasury notes have risen almost half a percentage tojust under 4.70% this week. That’s the highest since January 2025. This raises some obvious questions, such as what’s driving the rise and are the reasons mainly cyclical or should they be viewed as systemic and of deeper concern?
The increase in yields has been mostly driven by the business cycle and mainly for three reasons. First, the economy has grown more vigorously than anticipated. Consumer spending has been sustained despite the twin shocks of higher tariffs and energy prices crimping real incomes. Also, business investment outlays have surged due mainly to the AI infrastructure build-out. As a result, expectations about monetary policy have shifted from interest rate cuts to increases. A few months ago, the expectation was that the Federal Reserve would lower rates once or twice this year but now the prevailing wisdom is that it will tighten monetary policy later this year.
Second, the economy’s performance has caused market participants to revise up their longer-run expectations about the level of short-term rates that is consistent with a neutral monetary policy. It isn’t credible to judge monetary policy as restrictive when short rates have been above current levels for more than three years and the unemployment rate remains at a level judged by monetary policymakers to be consistent with full employment and stable inflation. The SOFR futures market, which shows the expected short-term rate path for several years, is around 4% after 2026, compared to the Fed’s current federal funds rate of 3.50% to 3.75%. If short-term rates are expected to be higher, then bond yields need to move up as well.
Third, the term premium that bond investors demand to hold longer-term Treasuries rather than shorter maturity ones has risen above the level prevalent in recent years. That should not be surprising given that the premium was unusually low following the Great Financial Crisis. Between 2009 and 2021, the worry was that short-term rates could be pinned close to zero and that the Fed would lose the ability to make monetary policy stimulative. In that environment, bonds were attractive and the term premium was around zero and even lower. However, prior to the GFC in environments more similar to today, the average spread between three-month Treasury bill rates and 10-year Treasury note yields was about 100 basis points. That is comparable to where the spread is today.
Despite this sanguine assessment, there are several reasons for deeper concern. First, the U.S. remains on an unsustainable fiscal path and the situation is worsening. On the expenditure side, the Iran war is boosting defense outlays, with President Donald Trump seeking a $500 billion increase to defense spending in fiscal 2027 at the same time higher interest rates are pushing up the government’s debt service costs. The bipartisan Congressional Budget Office projects that debt service costs will move sharply higher as chronic budget deficits drive up the federal debt burden and as low-cost debt issued between 2009 and 2022 and is refinanced at higher interest rates.
In the CBO’s 10-year projections, debt service costs rise from 3.3% of GDP in 2026 to 4.6% of GDP in 2036. Moreover, if rates are markedly higher than the CBO assumes (around 3.2% for the 3-month Treasury bill and federal funds rates and 4.3% for the 10-year Treasury note yield) then debt service costs will be much higher too. The CBO calculates that a 1 percentage point increase in the level of rates above what it has assumed would increase debt service costs by $600 billion in 2036 and$3.8 trillion over the next 10 years. On the revenue side, recent court rulings with respect to the legality of the Trump administration’s tariffs have created a new budget hole.
Second, concerns about the ability of the Fed to maintain its independence in its conduct of monetary policy could lead to a significant further rise in bond term premia. If investors fear that the Fed won’t be able to get the inflation rate back down to 2%, then inflation expectations will become unanchored and bond risk premia will increase even further. The fact that inflation has already been above the Fed’s 2% objective for five years increases the risk of such a loss of confidence and higher bond yields.
Third, the dynamics here are self-reinforcing. Higher deficits lead to higher interest rates. The CBO estimates that every 1 percentage point increase in the nation’s debt-to-GDP ratio raises long-term rates by 2 basis points. The 20 percentage-point rise in the federal debt-to-GDP ratio that the CBO projects over the next 10 years would imply a 40 basis point rise in long term rates. And, as the debt burden climbs, investors become more worried that the solution will be one of fiscal dominance in which monetary policy is subordinated to fiscal policy.
As the renowned economist Rudi Dornbusch explained it, financial crises take much longer than expected to arrive, but when they do, they come on much faster than one might have anticipated. If this occurs, a loss of confidence and a sharp rise in long-term rates would make the fiscal situation unsustainable—the bond market vigilantes—not seen since the 1990s—would be back.
By Bill Dudley
May 21, 2026
