CICC: Why are U.S. Treasury yields continuing to rise?

China International Capital Corporation (CICC) released a research note stating that U.S. Treasury yields have continued to rise since the beginning of the year. To explore the underlying DRIVE, the bank used the New York Fed's Adrian, Crump, and Moench (ACM) model to decompose the 10-year Treasury yield into expected future short-term interest rates and term premium. The results indicate that from January to August this year, the 10-year Treasury yield increased by a cumulative 48 basis points, of which 52 basis points came from the uplift in expected future short-term interest rates, while the term premium fell by 4 basis points. This suggests that the rise in yields this year primarily reflects economic recovery driven by AI investment expansion and the inflation risks associated with geopolitical conflicts, prompting the market to reprice the Federal Reserve's policy path. Furthermore, fiscal expansion does lead to government debt accumulation, which pushes up term premiums. However, research literature indicates that for every 1% increase in the U.S. government debt ratio, the corresponding term premium increases by only 2-3 basis points. This means that the rise in government debt since the pandemic can only explain about a quarter of the increase in term premiums and 15% of the overall yield increase, with the rest stemming from factors like monetary policy and inflation compensation. The shift in macroeconomic dynamics in the U.S. is also affecting the long-term equilibrium interest rate. Following the 2008 financial crisis, the U.S. economy experienced prolonged stagnation due to real estate deleveraging, coupled with a global savings glut, which led to persistently low interest rates. However, the current situation is different: driven by the AI wave, U.S. corporate investment is strong, financing demand is vigorous, pushing the neutral rate upward. The U.S. economy may be emerging from a post-2008 environment of "low growth, low inflation, and low interest rates," transitioning to a new investment cycle centered around AI. In this context, the central tendency of U.S. Treasury yields has also risen, and this process is seen as interest rate normalization. In the decade and a half following 2008, investors became accustomed to zero rates, the Fed's quantitative easing, and excess liquidity. However, if we look back at history, that period was precisely a special phase of the downward financial cycle, while the current environment resembles a return to normality. Looking ahead, the bank believes that as AI capital expenditure deepens and the U.S. manufacturing cycle restarts, the Fed may adopt a relatively tighter monetary policy, leading to elevated Treasury yields that may remain high or even increase further. From an investment perspective, high interest rates are not purely bad newsif they reflect an improvement in economic fundamentals and strong corporate profitability, the stock market may also be supported. However, if they represent market concerns over supply-side inflation (such as rising oil prices) and policy uncertainties, they could restrain risk appetite. Why are U.S. Treasury yields rising? To explore the DRIVE behind the rise in U.S. Treasury yields, the bank utilized the ACM term structure model proposed by the New York Fed, which decomposes the 10-year Treasury yield into two components: expected future short-term rates and term premium (Term Premium). The former reflects market expectations of the future path of Fed policy rates, while the latter reflects the risk compensation investors require for holding long-term bonds, such as inflation compensation, duration compensation, and credit risk compensation. Regarding term premium, this concept dates back to Keynes's liquidity preference theory. Keynes argued that individuals choose between cash and bonds as saving methods; those who believe future interest rates will be higher than current market rates will hold cash, while those who believe future rates will be lower will purchase bonds. When interest rates are very low, investors expect future rates to return to a higher normal level, and if they hold bonds, they risk experiencing capital losses (bond prices falling), thus preferring cash. In this situation, if the government wishes to sell bonds, it must offer higher interest rates as compensation, which forms the theoretical basis for term premium. Subsequent development of the preference hypothesis theory further elaborated on this idea. This theory suggests that investors do not universally shun long-term bonds but each have their preferred maturity structure. For instance, pension funds and insurance companies prefer long-term bonds, while money market funds prefer short-term bonds. However, the market is not entirely segmented; if other non-preferred maturity bonds can provide sufficient yield compensation, investors will be attracted to step outside their comfort zone and invest in these bonds. At this point, term premium represents the risk compensation long-duration bonds provide to attract asset allocation. So, what part of the yield rise has occurred this year? According to the ACM model, from January to July 2026, the 10-year Treasury yield rose by approximately 48 basis points in total. Among them, around 52 basis points came from the upward revision in expected future short-term interest rates, while the term premium fell by 4 basis points. This suggests that the rise in Treasury yields in the first eight months of the year primarily reflects the market's repricing of future Fed policy, shifting from an expectation of two to three rate cuts at the beginning of the year to an expectation of rate hikes, rather than a substantial widening of term premium. Further examination reveals that the rise in expected short-term rates primarily stems from two factors: first, the improvement in U.S. economic fundamentals. Strong AI capital expenditure and resilient household consumption, coupled with a robust employment market and rising manufacturing PMI, demonstrate that the economic recovery is expanding from AI investment into broader fields. The second factor is the resurgence of inflation risks, which prompts the Fed to maintain a neutral-to-tight monetary policy. Fed officials first released hawkish signals through the dot plot at the June FOMC meeting, followed by three committee members voting to support an immediate rate hike at the July FOMC meeting, indicating that decision-makers have shifted their focus back from employment to inflation. Entering July, in addition to the above factors, some other forces have also driven up the term premium of U.S. Treasuries, further supporting yields. First, large-scale bond issuance by technology companies has created a drain effect on the Treasury market. Secondly, increased uncertainty in the geopolitical situation in the Middle East and rising oil prices have heightened market concerns about inflation. Thirdly, the frequent and large-scale Treasury auctions by the U.S. Treasury have exacerbated temporary tightness in the funding environment. However, the bank believes that these factors more reflect the supply-demand dynamics of funds and geopolitical uncertainties rather than a sudden massive repricing of U.S. credit risks. After all, concerns about U.S. government debt have not just emerged recently. How significant is the impact of fiscal deficit? While sovereign credit risk is not the primary factor driving up Treasury yields recently, this does not mean that fiscal factors can be ignored. The continuous expansion of the fiscal deficit and rising government debt levels will still influence long-term interest rates through various channels. So, how much do fiscal factors contribute to the rise in Treasury yields? The bank will conduct further analysis on this. Government debt can push Treasury yields up through three channels: first, the preference mechanism (incomplete asset substitution). Government debt expansion usually indicates an increase in the issuance of medium to long-term Treasury bonds, and investors who prefer long-term bonds will require higher return compensation to absorb the additional duration, thereby increasing the term premium. Secondly, the sovereign risk premium mechanism. A high government debt ratio undermines expectations of fiscal sustainability, leading investors to demand additional risk premiums to compensate for potential default or refinancing risks. In the past, U.S. Treasuries benefitted from high liquidity and security, allowing the market to assign them high valuations and low yields, but as interest expenses continue to rise, the market will express concerns over refinancing pressures. Third, the inflation mechanism. Even without debt sustainability issues, the market may worry that the government will resolve debt through inflation or that the central bank will be forced to maintain high interest rates, demanding higher risk compensation. Additionally, private sector leverage can push up asset prices, while government leverage may lead to inflation (as fiscal funds typically enter the real economy), even if the government isn't intentionally seeking to resolve debt through inflation. The Fed's research estimates that for every 1 percentage point increase in the U.S. government debt ratio, the 10-year Treasury yield rises by about 4 basis points, of which the expected future short-term rate contributes about 1 to 2 basis points, while the term premium contributes about 2 to 3 basis points. Based on these calculations, from the fourth quarter of 2019 to the second quarter of 2026, the ratio of U.S. Treasury debt to GDP is projected to increase from 105.8% to 121.5%, a cumulative increase of 15.7 percentage points, corresponding to an estimated increase of the term premium of about 31 to 47 basis points. In contrast, the New York Feds ACM model indicates that during the same period, the term premium and yield of the 10-year Treasury rose by approximately 163 and 267 basis points, respectively. This means that the expansion of government debt can only explain about a quarter of the rise in term premium and 15% of the overall yield increase. The reevaluation of term premium largely reflects the elevation of the actual equilibrium rate, the rise in inflation risks, and changes in the long-term supply-demand dynamics rather than being solely attributable to sovereign credit risk. Of course, the above calculations more represent historical averages and cannot entirely account for short-term fluctuations. For example, at certain stages, the market may be particularly sensitive to U.S. government debt issues, leading to sharp increases in Treasury yields, while concerns regarding Japanese and European countries' debts may spillover to U.S. Treasuries. Looking ahead, the marginal impact of fiscal factors on future interest rates remains to be seen. According to projections from the Congressional Budget Office (CBO), by 2030, the U.S. government debt to GDP ratio will rise to 126.2%, an increase of 4.7 percentage points compared to the second quarter of 2026. Based on the aforementioned results, this corresponds to a further increase in term premium of only about 10 to 14 basis points. Even by 2036, when debt to GDP ratio rises to 136.4%, the additional raise in term premium would be only about 30 to 45 basis points. Historically, the CBO has often underestimated U.S. government debt forecasts. If future fiscal deficits exceed expectations, the market may re-evaluate the sustainability of U.S. fiscal policies and demand higher term premiums. However, currently, this risk should not be overstated. The Trump administration has not proposed any new fiscal expansion plans, and its major policy initiatives, such as tax cuts, have mostly been reflected in the previously passed American Rescue Plan Act, for which the market has already built sufficient expectations. Therefore, without additional fiscal stimulus, the gradual rise in government debt's impact on long-term interest rates remains to be observed. The wave of AI and interest rate normalization Changes in the U.S. macroeconomic landscape will also affect long-term interest rates. After 2008, the U.S. economy fell into prolonged stagnation due to the burst of the housing bubble, alongside a global surplus of savings, which created persistently low interest rates. The current situation has changed: under the impetus of AI, U.S. investment is robust, with the share of fixed asset investment related to AI surpassing that of real estate. At the same time, financing demands are high, corporate bond issuance is strong, and commercial bank loans are expanding rapidly. This suggests that the U.S. may be emerging from an environment of low growth, low inflation, and low interest rates into a new investment cycle centered around AI. Fed Chair Waller referred to this change during the 2026 Jackson Hole meeting as a hinge point in history. He also noted that as investments deepen, the potential for future growth is rising. The bank believes that while the growth rate of AI investment may fluctuate in the future, the current macroeconomic environment has changed significantly compared to the decade after 2008. This assessment is also supported by data: according to estimates from the New York Fed, the U.S. economy's trend growth rate has gradually rebounded from about 1.5% post-2008 to around 2.5%, and the real neutral rate (R*) has increased from a range of 0.5% to 1% to 1.5% to 2%. Simultaneously, U.S. nominal GDP growth rates have also risen markedly, reaching as high as 6.5% in the second quarter of 2026. In this context, the central tendency of U.S. Treasury yields has also risen, which the bank sees as a process of interest rate normalization. Over the past decade, the market has become accustomed to zero rates, the Fed's QE, and ongoing liquidity easing, treating these as a norm. However, from a longer historical perspective, the truly exceptional period was precisely the decade following the 2008 financial crisis, while the current state resembles a return to normal. Looking ahead, the bank believes that U.S. Treasury yields will remain elevated for a longer time and may even rise further. First, the current manufacturing cycle driven by AI is still on an upward trajectory, with the U.S. ISM Manufacturing PMI consistently climbing since early 2026, and core capital goods orders showing increasing growth, indicating that the spillover effects of AI investment are still expanding into broader sectors. Second, to counteract the inflation pressures brought about by investment expansion and rising oil prices, the Fed may restart rate hikes, which could lead to further revisions in future short-term rate expectations. Third, currently, both household and corporate sector balance sheets are healthy, with low leverage levels and historically low debt service burdens, meaning that private sector debt is less sensitive to rising rates and may require yields to rise to even higher levels to truly exert a restrictive effect. From an investment viewpoint, the bank believes that high levels of interest rates are not purely bad news if they reflect sustained improvement in economic fundamentals and strong corporate earnings, the stock market may benefit in tandem. However, if they symbolize concerns over supply-side inflation (such as oil prices) and policy uncertainties, this would be detrimental to the stock market. From January to August this year, the 10-year Treasury yield rose a cumulative 48 basis points, during which the S&P 500 index increased by about 12%. This indicates that the market possesses some capacity to absorb high interest rates.