The "hidden danger" behind the global bond market sell-off: the neutral interest rate is rising, and major central banks may need to adopt more aggressive rate hikes.

A storm of bond sell-offs sweeping across the United States, Japan, Germany, the United Kingdom, and Australia is pushing global long-term borrowing costs to levels unseen since the financial crisis. As bond investors demand higher returns from governments, they anticipate stronger economic growth, increased corporate borrowing and investment, and further interest rate hikes by central banks. As summer draws to a close, the cool September air has once again cast a chill over the sovereign bond market this week, while traders are preparing for possible interest rate hikes from Japan, Europe, and potentially the United States in the next three weeks. A major driver behind the surge in global bond yields: rising neutral rates The yield on the U.S. 10-year Treasury bond, sensitive to economic conditions, has soared to its highest level since President Trump returned to the White House early last year. The yield on Japans 10-year government bonds has surpassed 3% for the first time since 1996, while Germanys 10-year bond yield has hit a 15-year high. The yield on the UKs 30-year bonds has reached its highest level since 1998, and Frances 30-year bond yield has skyrocketed to an 18-year peak. However, as many economists have pointed out in recent months, the breakdown of these yields indicates that the latest trends are at least partly driven by real, inflation-adjusted yields rather than inflation expectations themselves, or the more nebulous term premium reflecting debt burdens or long-term inflation uncertainty compensation. The real yield on the U.S. 10-year bond has risen by about 40 basis points in just three months and surged again in the past week. During the same period, Japans 10-year real yield has nearly tripled to 0.9%, while France's 10-year real yield ranks among the highest since the eurozone's inception. Whatever the specific numbers, the neutral rate that balances these economies seems to be on the risewhich may not necessarily be bad news. However, as central banks adjust policies in response to an AI-driven investment boom and seek to re-establish policy impact on the economy, this shift could significantly raise borrowing costs over the next few years. Federal Reserve Chairman Kevin Walsh acknowledged this point during his speech last week at the Jackson Hole conference. He emphasized multiple times in his keynote address that current U.S. monetary policy shows little to no sign of suppressing loans or credit growth, and that financial conditions remain loose. Walsh asserted that unless inflation falls significantly back to the target level of 2%which is unlikely to happen before the Federal Reserve meeting on September 16the Fed has a lot of work to do. I find it hard to characterize overall financial conditions as restrictive, he said last Friday at the annual conference in Wyoming. Fed futures quickly responded to the signals, indicating a nearly 70% probability of an interest rate hike this month, up from only one-third previously. Perhaps most importantly, the market has fully digested expectations for two rate hikes prior to March of next year, and anticipates that the expectation of a third rate hike within the next 12 months will also reach half. In the upcoming two-year futures contracts, the policy rate (currently at a median of 3.625%) is unlikely to fall below 4% before 2028. This week, affected by the renewed tensions from the Iranian war situation, global crude oil prices have risen above $90 per barrel, adding further woes. But clearly, this situation is not solely about oil. AI-driven economic growth and the Fed's reassessment of neutral rates may prompt further interest rate hikes Walsh's remarks as chairman were notable, as he elaborated on how policy influences the economy, challenging the long-standing assumption among many Fed officials that rates are still slightly restrictive. If the Fed is reconsidering the neutral rate that neither stimulates nor drags on the economy, then rates are almost certainly set to be higher than current levels, and the market may adjust its expectations for real rates accordingly. The long-term nominal policy rate projected by Fed policymakers for the quarter is 3.1%, widely seen as a representation of neutral. However, this assessment may undergo substantial changes: this rate has risen from 2.4% in 2022 and once hit 3.8% in 2015. The Feds model suggests the real neutral rate (R*) lies between 1.0% and 1.65%. Adding a 2% inflation target implies that the neutral nominal rate would be close to current rates, near the upper end of that range. However, since the Fed's actual policy rate (measured against the current overall personal consumption expenditure inflation rate) remains near zero, the Fed does not appear to be tightening the economy in any substantial mannerif anything, it might still be stimulating economic growth, even though the growth stimulated by AI, inflation, investment, and financial conditions all indicate otherwise. Chip giant NVIDIA Corporation (NVDA.US) stated last week that there are signs the AI capital expenditure boom will last at least until next year, with expectations of a 70% sales growth by 2028. This suggests that the nature of the global economy may be shifting, compelling a reevaluation of the neutral rate model. At the very least, corporate borrowing is rising sharply, and the data center boom centered in the U.S. may well spread to areas outside the U.S. in the coming years. Even if you optimistically believe that productivity gains will drive faster economic growth, the construction and investment phases will also elevate capital costs due to a rebalancing of savings and investments. Walsh himself acknowledges this point, comparing the current boom to the stagnation period caused by excess savings, during which no one wanted to invest and rates fell to zero. For example, despite a year-long U.S. trade war, the AI race continues to boost global economic activity, as demonstrated by the OECD. Last week, the G20 indicated that the growth rate of merchandise trade accelerated in the second quarter. Quarterly import growth climbed from 5.2% in the first quarter to 6.7%, with AI-related chips and computing devices being the main drivers of this growth. It is likely that all major central banks are in a similar predicament to the Reserve Bank of Australia at the beginning of the year, when it quickly acted to correct its policy direction. It once lost sight of the trajectory of neutral rates, but given other economic indicators, it knew that earlier interest rate levels were too low. Subsequently, its task has been to continually raise rates while feeling its way in the dark toward neutralthis judgment itself may also change over time. It essentially acknowledges that you can only truly understand it when you are immersed in it. The Fed and other major central banks may very well be reaching the same conclusion.