Bond markets aren’t buying the inflation-is-tamed fairy tale

TOKYO — Anyone betting that inflation risks are fading should look at the US Treasury market.

The sharp selloff in Treasury Inflation-Protected Securities (TIPS) suggests the world’s biggest bond market is growing less convinced that price pressures are contained. Investors are rethinking the inflation outlook, with implications for Federal Reserve policy, real rates and stock valuations. The upward creep in conventional Treasury yields looks set to continue, and could accelerate.

Demand is already softening. Last week, the Treasury Department saw tepid interest in its $70 billion auction of 5-year notes, which sold at a yield of 5.033%, the highest for a 5-year auction since June 2006. Thirty-year yields are testing 24-year highs, and 10-year yields are near two-decade highs, as the Iran war‘s inflation shock shakes up the global economy.

Oil is the swing factor. “The ‘Yes, No, Maybe So’ jawboning over the Strait of Hormuz reopening is keeping investors on edge,” says Craig Johnson, chief market technician at Piper Sandler. Ian Lyngen, rates strategist at BMO Capital Markets, notes that the “historically strong correlation between oil and yields will leave the market particularly focused on the durability of the latest diplomatic efforts in the Middle East.”

Yet markets still don’t seem prepared for what may come. “It’s striking how many market participants have been surprised by the recent surge in US yields,” says Allianz economist Mohamed El-Erian.

“The fundamental drivers have been evident for some time. What’s playing a far larger role than it should is psychological anchoring: the collective mindset shaped by more than a decade of artificially low, repressed yields following the 2008 global financial crisis,” he says.

That complacency means the adjustment for global debt markets could be more sudden and disorienting than many investors admit.

The strain is already showing up in households. Thirty-year Treasury yields reached their highest level since 2002 on the same day the Conference Board reported that US consumer confidence had fallen to a 12-year low.

The two data points reflect the same problem: persistent inflation is fueling an affordability crisis. Gasoline above $4 a gallon, soaring diesel costs and surging heating oil prices are taking a heavy toll on consumer sentiment.

As Conference Board economist Dana Peterson puts it: “Consumers’ write-in responses regarding factors affecting the economy were mostly pessimistic in September. References to prices, the high cost of goods and services, and oil and gas prices in particular, rose to new heights.”

All this suggests that market action in the $2.153 trillion TIPS market is not irrational or an aberration. Rising real yields indicate that the market expects the US economy to remain resilient — at least in pockets thanks to AI — while inflation pressures intensify.

This trajectory speaks to the magnitude of the Federal Reserve’s policy dilemma. On Sept. 16, the Federal Open Market Committee hiked rates 25 basis points to a range of 3.75% to 4% in a unanimous vote. Even Fed Chairman Kevin Warsh, chosen by US President Donald Trump to lower rates, supported the tightening move.

This is kicking up a uniquely animated debate about whether the Fed has lost the plot. Count Moody’s economist Mark Zandi among those worried the Fed is making a mess of things by tightening into both internal and external shocks.

“The odds of a serious Fed policy mistake are uncomfortably high and rising,” Zandi noted, adding that “the economy is already growing near potential (2% real GDP growth) and operating at full employment.”

Zandi notes that the artificial intelligence boom is driving economic growth while non-AI sectors are losing momentum. The Fed’s choice is to actively slow AI investment that’s keeping both the economy and the stock market aloft, or to defend against slowing consumer confidence. “Neither is a good outcome,” Zandi says. “Of course, it doesn’t have to choose either. It can wait.”

The conventional wisdom is that the Fed will continue tightening — perhaps two more times by year-end. Some measures of market pricing suggest the Fed could be hiking rates in early 2027, too.

James Lord, global head of FX at Morgan Stanley, says the bank “now forecasts US dollar strength through year-end and into 2027.” He adds that “elevated energy prices, robust US data, and a hawkish ‌reaction function have generated not just a rate hike but likely further hikes to come.”

Perusing recent Fed comments, it’s hard to find policymakers who think the most powerful central bank is done tightening.

As Fed Governor Michael Barr puts it: “Economic growth is strong and the labor market is solid, but inflation is above our 2% target and not clearly trending toward target in a timely way. Moreover, risks to achieving our inflation target have increased, while risks to the labor market have receded. We needed to recalibrate monetary policy to reflect the balance of risks to our mandate goals.”

Barr explains that the “FOMC took important action to that end last week by increasing the policy rate, which I supported. In my view, given changes to the economy, we were out of position, and we made an adjustment in the right direction. In my base case, further policy adjustments are likely to be needed to ensure inflation comes down to target in a timely fashion. We want to support sustainable, durable growth in support of maximum employment, and price stability is crucial to that.”

The Fed’s dilemma is exacerbated by the US national debt topping $40 trillion around the same time as Warsh’s tightening cycle. Emre Tiftik, economist at the Institute of International Finance, notes that “as benchmark rates rise, interest expense is set to surge, while structural pressures from healthcare and public pension spending remain largely unaddressed.”

At the same time, mature-market governments now spend more on interest expense than the world invests in either AI, defense, or clean energy.

“The key question is what could trigger an inflection point in dollar demand,” Tiftik adds. “Episodes over the past year have tested the ‘debasement trade,’ yet US securities remained well bid despite heightened volatility and speculation, partly because alternative markets lack comparable depth and liquidity. However, as structural pressures—including heavy debt-service burdens—become more visible and binding, such episodes may become more frequent, and market reactions could be sharper and more abrupt.”

The TIPS selloff speaks to fears that heavy government borrowing and massive corporate debt issuance won’t just fuel inflation but will compete for the same pool of capital, reducing raw demand for government paper.

Federico Cesarini, head of FX at Amundi Investment Institute, adds that “a genuine tightening cycle is the key risk to our view. Our structural concerns about the USD lie in the interaction between US fiscal sustainability, the price of capital and the opportunity set outside US assets.”

The plot thickens when the IIF’s recent data are considered. At the end of June, global debt surpassed $365 trillion, surging more than $10 trillion in just six months. Washington-based IIF points to the US, Japan, France and the UK, which face “persistently large deficits and rising interest expenses — challenges long associated with debt-distressed emerging market sovereigns.”

Debt, Tiftik notes, has become a political issue, “creating a vicious cycle between elections and short-term quick fixes, and a long-term vulnerability as the marginal utility of higher debt diminishes.” He adds that as “benchmark rates rise, interest expense is set to surge, while structural pressures from healthcare and public pension spending remain largely unaddressed.”

Last week, the Organization for Economic Cooperation and Development said rising bond yields underscored the need to “contain and reallocate government spending, improve public sector efficiency and strengthen revenues.” The OECD warns that governments must urgently put public finances on a sustainable long-term path and ensure they can respond to future economic and market shocks.

International Monetary Fund managing director Kristalina Georgieva warns against “pushing debt levels up like a staircase not to heaven.” She tells the BBC that “there are these two things that must be done: bring debt levels down, put fiscal consolidation as a priority, and make sure that the central banks deliver on their mandate for price stability.”

Georgieva concludes that “it’s impossible to stress strongly enough how critical it is to get the courage to take the steps that are necessary. These are politically tough steps to take, but necessary steps to take.”

It’s early to lose perspective. As economist David Rosenberg, president of Rosenberg Research, points out, the last time many market interest rates were at today’s level, back in 2007, the level of world debt was $142 trillion and less than a 270% share of the global economy.

“The risks are far more acute today from a refinancing-risk perspective,” he notes, adding that Treasury yields and crude oil prices have “once again shifted from tailwind to headwind — a reminder that equities right now are highly sensitive to swings in bonds and oil.”

Perhaps the most surprising part of last week’s summit between Trump and Chinese leader Xi Jinping is the lack of agreement on even the most basic of economic logistics. If Treasury Secretary Scott Bessent is so worried about foreign central banks selling US government debt, why not forge a swap arrangement between the US and Chinese finance ministries that heads off such sales?

One could wonder, of course, whether Beijing would entertain such an idea, given that it’s already stuck with $618 billion in US Treasuries. Now that even Treasuries that aim to protect investors from inflation are on the ropes, getting the globe to bet on Washington’s fiscal credibility might be harder than ever.

Follow William Pesek on X at @WilliamPesek