Higher global bond yields:
what's really going on?

Bond yields influence everything from mortgage rates and company borrowing costs to equity valuations and expected investment returns. Understanding what is driving their rise is therefore important for investors.

While geopolitical events and fiscal concerns have certainly played a role, in our view, they don’t tell the whole story. A more important explanation lies elsewhere: a significant part of the move in yields reflects a shift in the economic environment and a gradual move away from the unusually low interest rates that prevailed in the aftermath of the 2008 global financial crisis (GFC).

A very different world

To understand what is driving yields higher, it is useful to consider how much the economic backdrop has changed since the years following the GFC.

Much of the current discussion around rising bond yields focuses on inflation. While inflation remains relevant, market pricing suggests that long-term inflation expectations remain relatively well anchored. Instead, much of the increase in yields has come from higher ‘real yields’ – the return investors expect above inflation.

One explanation lies in the changing balance between the supply of savings and demand for capital.

During the decade following the GFC, households, businesses and banks focused on repairing their balance sheets and reducing debt. Investment spending remained subdued, savings were plentiful and central banks injected extraordinary amounts of liquidity into financial markets. Capital was abundant and borrowing costs fell to exceptionally low levels.

The world looks very different today. Governments continue to run large deficits and borrow heavily, while businesses are investing aggressively in artificial intelligence (AI) infrastructure, data centres and digital technologies. These projects require enormous amounts of capital and increasingly compete with governments for investor funds. As demand for capital rises relative to the supply of savings, its price naturally rises too, as reflected in higher bond yields.

Central banks have also stepped back from the extraordinary bond-buying programmes that characterised the post-GFC era. With inflation still above target in many economies and labour markets generally healthy, there is far less justification for suppressing long-term interest rates.

Historical perspective

Against this backdrop, today’s yields appear less extraordinary than many assume. Economic growth is stronger, investment spending has recovered and demand for capital has increased. Bond markets are adjusting accordingly.

Viewed through a longer historical lens, what we are witnessing looks less like a crisis and more like a normalisation after an extended period of exceptionally low interest rates. That doesn’t mean yields can’t rise further, but it does challenge the idea that every increase should be interpreted as evidence of severe market stress.

Broader economic forces

The growing US debt burden has become a popular explanation for higher yields. Fiscal sustainability is certainly worth monitoring, particularly if governments continue to run large deficits during periods of strong economic growth. However, there are several reasons to be cautious about attributing the recent rise in yields solely to concerns about US government finances:

• US government borrowing costs remain below nominal growth in gross domestic product (GDP). Historically, this has not been consistent with the debt dynamics typically associated with an imminent sovereign funding crisis.
• US government debt is denominated in US dollars. While this doesn’t eliminate fiscal risk, it provides considerably greater flexibility than countries that borrow in foreign currencies have. The US Federal Reserve also retains the ability to buy government bonds during periods of extreme market stress.
• Rising yields are a global phenomenon, rather than a uniquely US one. Government bond yields have also moved higher across Europe, the UK and Japan. If investors were genuinely abandoning US government bonds, we would likely expect a significantly weaker US dollar and a much larger divergence between US and other developed-market yields than we have observed.

None of this suggests fiscal risks are irrelevant. Over the longer term, they may become increasingly important. For now, however, the evidence suggests that broader economic forces are playing a significant role in the repricing of global bond markets.

Implications for investors

For global bond investors, higher yields can be painful in the short term because bond prices move inversely to yields. The sharp increase in rates over recent years has resulted in capital losses across many fixed-income markets. Yet increased yields also improve the outlook for longer-term returns.

The income received from a bond, often referred to as its carry, plays an increasingly important role in determining long-term returns as yields rise. A higher starting yield provides a larger cushion against future price fluctuations and reduces the likelihood of negative returns over longer investment horizons. In other words, falling bond prices today can make the asset class more attractive over time. By contrast, strong equity market performance and rising valuations can lower expected returns from shares.

Investors should therefore avoid becoming anchored to recent performance trends. Assets that have struggled in recent years may offer better value going forward, while those that have performed exceptionally well may deliver more modest returns in future.

Our view of the cycle

Despite higher bond yields and geopolitical turmoil, global equity markets have remained resilient. Strong nominal GDP growth and accelerating corporate earnings have continued to provide support.

For now, we believe the balance of probabilities favours global equities over bonds. Economic growth remains supportive and company profits continue to expand.

That said, every cycle eventually matures. If bond yields remain elevated, financing conditions will tighten, economic growth will gradually slow and equities will face a more challenging environment. At that point, the relative attractiveness of bonds is likely to improve.

We’re not attempting to predict the precise path of yields over the coming months, a question on which investment firms hold sharply differing views. What matters more is understanding how changes in bond markets affect the broader investment landscape and remaining flexible as conditions evolve.

While today’s environment still favours equities, the return potential of fixed income is steadily improving. After a prolonged period of equity outperformance, complacency is a growing risk. When the evidence suggests that the current cycle is losing momentum, we would expect bonds to become increasingly attractive relative to equities. As active asset allocators, that is precisely the kind of change we’ll continue to monitor closely.