Bonds under pressure: Why the market is entering a new era of interest rates

Global sovereign bond markets are heading for one of their worst months in years as rising energy costs fuel inflation and the artificial intelligence boom supports economic growth, forcing investors to reassess expectations for interest rates.

Two-year US Treasury yields have surged nearly 60 basis points in September and are on course for their sharpest monthly increase since early 2023.

Borrowing costs on two-year government bonds in France, Germany, Britain and Australia are also set for their biggest monthly increases since March, when the Iran war triggered a fresh energy shock. Japanese government bond yields remain close to multi-decade highs.

The moves signal a broader shift in bond markets, with investors increasingly preparing for an environment in which interest rates remain elevated for longer than previously expected.

Higher rates reshape bond markets

Government bond markets are closely watched because their yields influence borrowing costs across the economy, including mortgages, corporate loans and other forms of credit.

A sharp rise in yields can increase financing costs for households and businesses and potentially weigh on economic activity.

The latest moves come against a backdrop of stronger inflation pressures and resilient economic growth. Unlike the low-rate environment that dominated much of the previous decade, investors are now having to contend with higher absolute borrowing costs.

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The 10-year US Treasury yield has moved above 5 per cent for the first time since 2007 and is on course for its biggest monthly increase since 2022, with a rise of around 50 basis points in September.

The rise in Treasury yields has also fed through to the US housing market. The rate on the most popular US home loan recently climbed to its highest level in more than two years, increasing borrowing costs for homebuyers.

Bond-market volatility has risen sharply as investors adjust to the new interest-rate environment. The ICE BofA MOVE Index, which measures volatility in the US Treasury market, has jumped nearly 30 per cent this month, marking its biggest monthly increase since March.

For some investors, however, higher yields are making government bonds more attractive because they offer greater income after years of relatively low returns.

Inflation remains a key concern

The renewed pressure on bond yields comes as energy costs add to inflation concerns.

The energy shock has made it more difficult for central banks to assume that inflation will continue moving steadily towards their targets. Persistent price pressures could limit the scope for interest-rate cuts or keep policymakers cautious about easing monetary policy.

Markets will therefore closely watch upcoming inflation and employment data for signs of whether price pressures are becoming entrenched.

The US Federal Reserve remains particularly important for global bond markets because changes in expectations for US monetary policy can influence yields and currencies worldwide.

Investors are also assessing the outlook for government borrowing, with large fiscal deficits adding to the supply of bonds that markets need to absorb.

AI spending adds another layer of pressure

The surge in artificial intelligence investment is creating another source of borrowing demand.

Large technology companies are increasingly turning to debt markets to finance spending on data centres, computing infrastructure and other AI-related investments.

Bond sales by major technology companies have more than doubled this year to more than $200 billion, according to LSEG data.

The increase in corporate borrowing could compete with governments for investor demand and contribute to pressure on longer-term yields.

The combination of heavy government issuance and rising corporate borrowing means investors could demand higher returns to absorb the additional supply of debt.

Europe faces fiscal challenges

European bond markets are also dealing with country-specific fiscal and political risks.

France’s 10-year government bond yield has risen more than 50 basis points this month, marking its biggest monthly increase since 2022.

The spread between French and German 10-year borrowing costs has widened to its highest level since 2012, reflecting growing concerns over France’s fiscal outlook and uncertainty surrounding its budget negotiations.

The UK’s fiscal position will also remain in focus as the government prepares its upcoming budget under new finance minister John Healey.

These developments are adding to broader concerns about government debt levels at a time when borrowing costs are significantly higher than they were during the era of near-zero interest rates.

October could bring more volatility

Investors are heading into October with several major economic and fiscal events on the calendar.

The latest US jobs and inflation data will provide clues about the Federal Reserve’s next steps and the direction of Treasury yields.

Markets will also monitor French budget negotiations and the UK’s budget for signs of how governments intend to manage their finances in a higher-rate environment.

At the same time, further debt issuance by technology companies could add to competition for investor capital.

The combination of persistent inflation, stronger growth, heavy government borrowing and rising corporate debt issuance is forcing bond investors to adjust to a market where higher interest rates may become a more lasting feature.