Amid the continual swirl of geopolitical noise, macro and monetary policy uncertainty, and equity market volatility from the artificial intelligence super cycle, it is easy to lose sight of the all-important real yield levels.
Having shot up to multiyear highs in recent years, the risk now is that real yields—the cleanest read on the underlying cost and availability of capital in the economy—could move higher still, potentially constraining economic growth as the higher cost of capital chokes off investment.
We have seen this several times over the past two decades, where higher real yields have precipitated a recession.
To be clear, with current real interest rates at roughly 1% for the fed funds rate and 1.7% for the 10-year Treasury, we are some way off the historical growth impact trigger level of about 3 – 4%, as we highlighted in our 3Q Fixed Income Outlook. But today's level is, in our view, a warning sign that growth, while currently solid at 1.5 – 2%, could start to be threatened, and the direction of travel following the Federal Reserve’s meeting last week only sharpens that concern. Indeed, the 30-year real rate touched 3.0% for the first time since 2002, a reminder that parts of the curve are edging into territory where higher borrowing costs can begin to bite.
Forces Driving Real Yields Higher
This growth risk is precisely what the Fed must weigh in balancing its dual mandate, and part of the reason why it held rates steady at 3.5 – 3.75%, as expected.
Fed Chair Kevin Warsh acknowledged the scale of the move, noting that nominal and real Treasury yields have shifted materially higher, among the largest moves in two decades as markets focused on the data.
His framing was telling; participants, he said, have “learned to play the ball, not the referee.” That dynamic showed up in the curve immediately, with the front end easing modestly while the back end moved sharply higher.
Yet the Fed’s decision tells only part of the story. The prevailing narrative is that rates have risen this year on inflation fears and the hikes that follow. We believe that is largely wrong. What has actually driven this year's bond market has been a rise in real yields, not inflation expectations, accounting for 85 – 90% of the 10-year’s move.
The market is therefore not pricing higher inflation; it is pricing the demand and supply of capital, driven by AI infrastructure spending layered on persistently high government borrowing needs. A further escalation in either could push real yields meaningfully higher still. That is not our base case, but watching both forces, rather than inflation data, is the more useful exercise for gauging where real yields go next.
Non-Consensus View on Inflation
This distinction is critical, because our house view diverges from consensus most clearly on inflation, and yet inflation is not the lever that will ultimately determine where real yields settle.
We believe inflation is on track to move back toward central bank targets sooner than the market expects, likely to be more pronounced toward the end of the year. The tariff impact appears to have largely burned off, and we see limited evidence of material pass-through from the earlier energy price shock into core inflation.
By year-end, we expect the Fed to be within close reach of its inflation target. That matters because stabilizing inflation is a necessary, but not sufficient, condition for yields to fall meaningfully. Across the major developed markets—the Fed, the European Central Bank, the Bank of England—we believe too much hiking is still priced into curves, and central banks are far more likely to transition into an extended hold than to deliver the aggressive tightening the market has periodically flirted with.
That said, to generate a substantial decline in real yields, inflation stabilization alone will not be enough. In our view, a rethink of the AI capex investment boom is the most likely mechanism for that. Absent that, we expect real yields to remain elevated, if range-bound, for the balance of the year, with the Fed’s more limited communication only adding to the dispersion in market expectations about the path ahead.
Look to Duration and Watch for the Signals
For portfolios, we believe this makes duration look attractive at current levels, though this reflects a considered allocation rather than a maximum conviction position. We have added duration exposure across portfolios, concentrated in front-end points, and have recently shifted toward a steeper curve positioning.
At today’s levels, long-end rates carry more uncertainty, tied closely to unresolved fiscal questions, and we remain more cautious there. Portfolios are generally running extended duration relative to benchmark, but deliberately short of maximum exposure.
The way we see it is that investors should not fear real yields at current levels, but they should watch closely for signs that the gap between real yields and underlying growth is widening and recognize that what moves yields meaningfully lower from here is less likely to be a Fed pivot than a shift in how markets price the AI capital spending story itself.
What to Watch For
Monday 08/03:
- U.S. Manufacturing Purchasing Managers’ Index
- U.S. ISM Manufacturing Purchasing Managers’ Index
- Eurozone Manufacturing Purchasing Managers’ Index
- U.K. Manufacturing Purchasing Managers’ Index
Tuesday 08/04:
- U.S. JOLTS Job Openings
Wednesday 08/05:
- U.S. ADP Nonfarm Employment Change
- U.S. Services Purchasing Managers’ Index
- U.S. ISM Non-Manufacturing Prices
- Eurozone Services Purchasing Managers’ Index
Thursday 08/06:
- U.S. Initial Jobless Claims
Friday 08/07:
- U.S. Nonfarm Payrolls
- U.S. Unemployment Rate
- U.S. Average Hourly Earnings