There's a new worry keeping Treasury yields and borrowing costs higher

By Joy Wiltermuth

Investors see a new floor under longer-duration Treasury yields

Treasury yields are higher, along with oil prices, but there's an inflation risk emerging.

As if global oil above $100 a barrel wasn't enough.

A new worry facing the $30 trillion Treasury market is that inflation from the artificial-intelligence spending boom could keep the Federal Reserve from cutting rates by much more.

As Pimco's Tiffany Wilding said in a Thursday client note, "something unusual" has been going on with U.S. inflation data since late last year - beyond the oil shock from the Iran war.

Wilding, an economist, looked at the two main gauges the Federal Reserve uses to help set monetary policy, which have been flashing quite different signals.

While the "core" component of the consumer price index has been mild, the below chart shows core inflation in the personal-consumption expenditures index jumping in 2026.

Core inflation looks mild based on CPI in 2026, but not on PCE.

Core index readings strip out food and energy prices, which tend to be volatile, especially this year's nearly 70% surge in U.S. (CL00) and global (BRN00) oil prices.

The two inflation indexes don't always move in lockstep because they use different formulas and weightings for things like shelter, financial services, and information and communication products and services.

A notable part of their divergence in 2026 can be traced back to accelerating "technology-related inflation," according to Wilding. She pointed to higher demand and costs for chips, memory and servers that have been spilling into consumer products, as well as price increases to come.

"That's just the way the cookie crumbles," said Ed Al-Hussainy, portfolio manager and global rates strategist at Columbia Threadneedle Investments. "If you're a policymaker, you just can't feel comfortable with this level of inflation."

Al-Hussainy pointed to tariffs, oil, AI and other residual areas that have kept inflation above the Fed's 2% annual target in the wake of the pandemic. "Making the case for cuts [now] has become very tough," he said. "The interest-rate market is picking up on that."

Rising inflation pinches households and can keep borrowing costs elevated. Several global central banks have already raised interest rates or talked about the possibility of doing so because of the oil shock from the Iran war.

Optimism around a one-page memo on Wednesday to end the Iran war pushed the S&P 500 SPX and Nasdaq composite COMP to fresh highs. Oil prices fell and the Treasury market rallied, sending yields lower.

Those moves eased Thursday on doubts about a swift resolution to the conflict. The 10-year Treasury yield BX:TMUBMUSD10Y moved up 4 basis points to 4.393% and the 30-year yield BX:TMUBMUSD30Y climbed closer to the 5% threshold. After the bell, reports that the U.S. and Iran traded attacks sent oil futures higher.

"The situation in Iran is certainly the primary driver of longer-duration yields, as it has been for the better part of two months," said Chip Hughey, managing director, fixed income, at Truist Advisory Services.

Yet with AI spending estimated at $700 billion this year, and projected to grow over the next few years, it's a "very powerful engine" underpinning the U.S. economy, Hughey said.

While the Iran war and the spike in energy prices raised the floor on how low yields could go versus earlier this year, U.S. economic resilience from the AI race also suggests that if yields decline, any move might not be to a "tremendous degree," he said.

The odds on Thursday favored no Fed rate cuts this year, but were close to 17% for a rate hike, according to the CME FedWatch Tool.

-Joy Wiltermuth

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

05-07-26 1841ET