US Bond Yields Surge Amid Inflation, AI Investment, and Federal Debt Concerns
On September 16, the Federal Open Market Committee (FOMC) of the US Federal Reserve will meet to decide on interest rates, currently set between 3.5% and 3.75%. Since the last decision in July, market expectations have shifted significantly. Initially, markets priced in nearly a 100% chance of a rate hike in September, but now that probability has dropped to around 30%, according to Yaniv Bar, head of economics at Bank Leumi.
Two main factors have driven this change: easing inflation and weaker labor market data. Recent Consumer Price Index (CPI) and Producer Price Index (PPI) figures indicate a slowdown in annual inflation, suggesting a convergence toward the Fed's target. Additionally, July's labor data showed weaker-than-expected job growth and a drop in labor force participation, which dampened expectations for rate increases. However, markets still anticipate a full rate hike by the end of 2026 and another in 2027.
Bar highlights that inflation has been accelerated recently by energy prices and investments related to artificial intelligence (AI). While energy inflation has somewhat moderated, AI-related costs continue to rise. The Fed is actively studying AI's impact, with short-term inflationary effects expected due to high demand for components, but medium- to long-term effects may be disinflationary through efficiency gains.
Despite the easing rate hike expectations, long-term US Treasury yields have risen, reflecting a higher term premium. This is driven by concerns over large government deficits in major economies, uncertainty from the Fed's communication, and increased competition for savings from companies issuing debt for AI investments. Japan's monetary normalization, which involves selling US bonds, also adds to supply pressures. Attempts by the US Treasury to counter this by increasing bond buybacks have had limited effect.
Bar concludes that addressing the issue requires credible plans to reduce the large US budget deficit, projected to remain around 6%-7% of GDP in coming years. Currently, there is no bond market crisis, but yields and term premiums are at levels seen before. In Israel, bond yields have risen less sharply than in the US, likely due to different interest rate paths.
Summary: The US bond market is experiencing rising long-term yields despite softer rate hike expectations, driven by easing inflation, AI investment demand, and concerns over large government deficits and bond supply. The Fed's upcoming September meeting will be closely watched amid these dynamics.
