Inflation concerns rekindle, Bank of America calls for interest rates to return to the "5 era."

Bond traders from around the world are finally waking up to the realization that the era of low interest rates may be gone for good. According to GMTEight Source, surprising resilience in the US economy, escalating debt and deficits, as well as growing concerns about the Federal Reserve's commitment to keeping rates high, are driving long-term US Treasury yields to their highest levels in over a decade. Strategists at Bank of America are warning investors to prepare for a world where rates hit 5%. Before the global financial crisis ushered in an era of near-zero interest rates in the US, rates of 5% were prevalent. BlackRock and Pacific Investment Management Co. (PIMCO) suggest that inflation may stubbornly remain above the Fed's target, leaving room for further increases in long-term yields. Jean Boivin, former Bank of Canada official and current head of BlackRock Investment Institute, said, "The repricing of long-term rates has been significant." He added, "The market is increasingly believing that, despite the progress we've made recently, there will still be ongoing pressures on inflation in the long term. Going forward, there will continue to be a question mark around the macroeconomic uncertainty, which requires greater compensation for holding long-term bonds." While higher rates will offset the impact by increasing interest payments to bondholders, they may also put pressure on consumer spending, home sales, tech stock valuations, and more. Additionally, higher rates will increase the cost of financing for the US government, further worsening the deficit. The US government has already been forced to borrow around $1 trillion this quarter to fill the gap. US bonds being sold off The sell-off in US long-term bonds in recent weeks has hit the hardest and erased the gains in the overall Treasury market this year, potentially marking the third consecutive year of decline. Soaring US bond yields have also weighed on the US stock market. The recent shift may prove to be a mistake, as some Wall Street forecasters continue to call for an economic slowdown, which could bring downward pressure on consumer prices. Furthermore, with the pace of inflation significantly slowing down from last year's highs, inflation expectations for this year remain stuck, signaling that the market anticipates inflation to eventually fall back to around the Fed's 2% target. The Fed's favored inflation gauge, the Personal Consumption Expenditures (PCE) Price Index, rose 3% in June, down from 7% a year ago. But many now foresee a soft landing for the US economy, making inflation the primary risk. The minutes from the Federal Open Market Committee's (FOMC) July meeting, released earlier this week, highlighted this concern, with officials expressing worries about the need for further rate increases. They also suggested that even if the Fed decides to lower rates to ease policy constraints, they may continue to reduce the size of their bond holdings, potentially dragging down the bond market further. US Treasury yields rose for the sixth consecutive day on Thursday, with the benchmark 10-year Treasury yield briefly climbing to 4.33%, just below the highest level seen since October 2007. The 30-year Treasury yield reached 4.42%, the highest in 12 years. US 10-year Treasury yields bid farewell to the era of declining yields Major changes in the broader economy are also causing speculation that low rates and low inflation in the post-crisis era were anomalies. Reasons for this include an aging workforce pushing wages higher, shifts away from globalization, and efforts to combat global warming by reducing the use of fossil fuels. Kathryn Kaminski, Chief Research Strategist and Portfolio Manager at AlphaSimplex Group, said, "If inflation remains elevated, I don't want to hold long-term bonds." "People will need more term premium to hold long-term bonds," she said. Term premium refers to the additional compensation investors typically demand to bear the risk of not using their funds for a longer period of time. Though yields have risen recently, this premium has not reappeared. In fact, with long-term rates below short-term rates (or an inverted yield curve, often seen as a precursor to an economic recession), the term premium remains negative. However, this spread has started to narrow, with the New York Fed's term premium gauge shrinking from around -1% in mid-July to about -0.56%. Term premium remains negative US federal spending is also adding to the upward pressure on yields. Despite the US economy being at or near full employment, the US continues to issue a significant amount of new debt to cover the deficit. Meanwhile, the Bank of Japan has finally decided to allow 10-year bond yields to rise, potentially reducing Japan's demand for US Treasuries. Boivin of BlackRock says central banks around the world are undergoing a major transformation. He states that these banks had kept rates far below neutral levels for years to stimulate the economy and ward off deflation risks. "Now the situation has reversed," he said. "So even if the long-term neutral rate has not changed, the central banks are going to keep a policy that is above the neutral rate to avoid inflation pressure."