By Joseph Adinolfi and Philip van Doorn

Bond-market experts expect a continued narrowing of the Treasury yield curve

Treasury bonds Increase Yield

The roughly $30 trillion Treasury market - widely seen as the bedrock of the global financial system - is facing a dangerous reckoning driven by a perfect storm of rising risks.

On Wall Street, bond-market professionals are warning that the tremors could affect your portfolio - whether you own bonds or not.

Long-end Treasury yields have been creeping higher for months, driven by several factors that could prove deleterious to the bond market's long-term health. On July 31, the yield on the 30-year Treasury bond BX:TMUBMUSD30Y traded as high as 5.281%, according to Tradeweb data. That was the highest reading since the summer of 2007. Yields have remained just shy of that level ever since, including a near-retest on Tuesday.

Before the start of the Iran conflict, the outlook for the Treasury market was looking far more benign. But as crude-oil prices shot higher, they caused yields to climb in lockstep as rising energy prices reignited inflation fears.

Since the start of the summer, bond-market experts have spotted signs that other potentially troubling factors have been driving the latest leg higher in yields. In a recent report shared with MarketWatch, David Rosenberg, founder of Rosenberg Research, said an expanding term premium is a durable trend that will continue to steepen the yield curve.

"The long end of the curve is fighting a lot of forces," said Andrew Szczurowski, strategic income portfolio manager at Morgan Stanley Investment Management.

"These include massive deficit spending, not only in the U.S., and massive spending on defense in Europe and in Japan," he said during an interview with MarketWatch. He told MarketWatch that another factor pushing up bond yields was "hyperscaler megacap debt flooding the market," as those companies fund the build-out of data infrastructure to support generative artificial intelligence. Yields have been rising in bond markets around the world, not just in the U.S.

Szczurowski co-manages the $19 billion Eaton Vance Strategic Income Fund ESIIX. He told MarketWatch that he expects the Treasury yield curve to continue to steepen as long-end rates move higher.

A bond-market measure of real yields - which strips out the impact of expected inflation - recently reached its highest level since October 2023, according to data collected by the Federal Reserve.

So far, the move in yields has proven sticky, even in the face of economic data that might have been expected to push yields lower. Yields on 10-year and 30-year Treasury bonds briefly dipped after Friday's July payrolls report showed a surprise decline in the number of jobs, but the move was quickly reversed - something Rosenberg flagged as concerning. On Wednesday, a July inflation report showed prices rose roughly as expected last month. Yields were generally unchanged after the data, slightly lower on the day.

Although crude-oil prices have remained elevated, bond investors appear less concerned about the long-term inflation outlook. After seeing a sharp rise earlier in the year, the five-year break-even inflation rate - a popular measure of inflation expectations based on bond-market prices - has been trending lower. This gauge is based on the difference between the yield on a 5-year Treasury note and its inflation-protected cousin. Bond yields move inversely with prices, rising as prices fall.

Rising inflation expectations are often fleeting, and therefore represent a less serious threat to bond market stability. But the fact that real yields and the term premium - a model-based measure of the greater returns investors demand for holding longer-dated bonds - have been rising suggests the problems facing bond investors might be more entrenched, Rosenberg said.

"If this was all about inflation and inflation expectations, the 10-year yield would be sub-4.4% right now," Rosenberg told MarketWatch. "A lot of this is confusion from the last Fed meeting. [Fed Chair Kevin] Warsh owns a good part of this," he added.

Worries about the Fed's credibility are beginning to dent the appeal of U.S. debt for investors both at home and abroad. Furthermore, the most recent joint intervention between the U.S. and Japan to support the sinking Japanese yen was carried out in a way that could further alienate the global investor community, Rosenberg said. As for the rising term premium, Rosenberg attributed it to growing uncertainty linked to the still-unresolved conflict in Iran.

Szczurowski cited Bloomberg data when pointing out that foreign ownership of U.S. Treasury paper had declined over the past decade to 23% from roughly 33%. "There is less official buying" by governments, he said.

But Szczurowski stressed that foreign investors' and governments' diversification of their bondholders didn't necessarily threaten the dollar's status as a reserve currency.

"There is not some other gold standard that is the alternative to the dollar. What do you have confidence in? There is no answer," Szczurowski said.

Beyond this, a flood of issuance of investment-grade investment bonds is crowding out demand for long-dated Treasurys. "This larger supply alongside more tepid demand from global investors, higher global bond yields, fiscal worries, and heavy hyperscaler issuance have all pushed yields higher," he said.

All of this could eventually create problems for the stock market by dampening economic growth, Rosenberg said. Investors have seen a preview of this dynamic already over the past couple of weeks. Rising Treasury yields were blamed for briefly putting pressure on equities following the most recent Fed press conference late last month. The dynamic also surfaced on Monday, as major equity indexes sank while yields pushed higher.

Last week, the Treasury Department released its quarterly refunding announcement, which laid out the schedule of bond auctions that will be held to raise money for the government over the coming months. A bump in supply of long-dated bonds tied to the refunding is contributing to Treasury market jitters this week, said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities.

Treasury yields were lower in recent trade on Wednesday, although they remained near the upper bound of their recent range. The yield on the 10-year Treasury note BX:TMUBMUSD10Y was off by 3 basis points at 4.656%, according to FactSet data. On the shorter end of the curve, the yield on the 2-year Treasury note BX:TMUBMUSD02Y was off by 4 basis points at 4.182%.

-Joseph Adinolfi -Philip van Doorn

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