Why are long-term bond yields rising?

The recent rise in long-term US yields is often attributed to a more restrictive Federal Reserve stance or a higher term premium. While valid, this explanation is incomplete. Long-term real yields are not purely a monetary phenomenon: they also reflect the economy’s cost of capital. Viewed through this lens, the focus shifts from why investors require higher compensation for holding long-dated bonds to why capital remains in such strong demand, and at what return it can be deployed. 

Government financing needs, the persistent strength of private investment and the rise of very large, debt-financed projects all point to sustained demand for capital. But elevated real yields could signal more than scarcity – they may reflect higher returns on capital as productivity accelerates. 

In this edition of Simply put, we examine why yields are rising and whether capital demand or capital productivity is the dominant force shaping their level.

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What the research tells us

Economic research frames this issue in straightforward terms: the real interest rate is the cost of capital. It results from the balance between a slowly moving supply of capital and a more variable demand, shaped by the cycle, financing needs and expected returns. This intuition is present in Jorgenson’s foundational work¹ and in his work with Hall², both of which directly link investment to the cost of capital. It is extended by the research on the equilibrium real interest rate, notably Laubach and Williams³, and alongside Holston⁴, which shows that real rates depend on structural forces shaping both the supply and demand for capital. More recently, Rachel and Summers⁵, as well as Caballero, Farhi and Gourinchas⁶, have shown that movements in real rates can be read as the outcome of imbalances between the supply of savings, the demand for assets and the demand for capital. 

In this framework, three variables account for most of the adjustment: public debt, private investment and capital productivity. The latter plays a distinctive role, because it does not merely increase investment needs; it also raises the expected return on capital. Elevated real yields may therefore reflect two distinct realities: capital becoming scarcer relative to demand, or capital becoming more productive. The key question today is which of these two forces dominates?

Drivers of the cost of capital

This framework finds a natural extension in Figure 1, which compares 10-year real yields with the three drivers of capital demand: public debt growth, capital productivity and investment. 

The chart shows that these theoretical mechanisms leave a visible imprint on the data. A first, crowding-out effect appears in the relationship between public debt growth and real yields: when public financing needs rise, real yields tend to move higher as well. The relationship with productivity is also visible, particularly during periods of technological boom, such as the late 1990s or more recently, when an improvement in the return on capital appears consistent with higher real yields. Finally, excess investment relative to its trend – estimated here using a Hodrick-Prescott filter – also shows a positive relationship with real yields. That relationship is admittedly less visually clear, but it usefully completes the overall picture. This first observation does not yet disentangle the various channels, but it does illustrate how consistent the level of real yields remains with an interpretation based on capital demand and the return on capital.

FIG 1. 10-year real yields and the drivers of capital demand⁷

Are real yields close to fair value?

Figure 2 extends this analysis by combining these three factors within a single regression in order to compare their explanatory power with the actual level of real yields. The point is no longer simply to note that public debt, productivity and investment move in the same direction as real yields at certain times, but to test whether, taken together, they provide a coherent explanation of them.

That is precisely what the chart suggests. The fitted series explains a significant share of real yield movements, with an R² of 69%, and shows that their recent level remains broadly close to what these fundamentals would imply. 

One important point emerges here: the contribution of the term premium – often associated with rising public debt through the additional political risk it may embody – does not replace the contribution of debt growth itself; it adds to it. In other words, even after accounting for that component, the effect of public demand for capital remains visible in the data – commonly referred to as a crowding-out effect. More importantly, the regression suggests that a real yield of around 1.6% remains consistent with the current macroeconomic backdrop. Unless the term premium compresses materially, it is therefore difficult to anticipate a pronounced decline in US real yields.

FIG 2. 10-year real yields: observed level versus level implied by fundamentals⁸

What the current decomposition tells us

Figure 3 takes the analysis one step further, moving from a broad explanation of real yields to a more granular ranking of their determinants. The sensitivity chart first shows that not all factors carry the same weight: a 1% increase in capital productivity has the strongest effect on real yields, far ahead of the term premium and investment, while public debt appears to have a much more limited impact. All else being equal, a roughly 10% increase in debt leads to an increase in real yields of around 40 basis points, an estimate consistent with the impact of recent announcements of public investment plans.

The decomposition of the current level points to the same conclusion. While the term premium continues to contribute to the firmness of real yields, it does not fully explain it; productivity and investment also account for a substantial share, while the direct contribution of debt remains more modest. 

Overall, today’s real yields do not deviate materially from what these fundamentals would suggest. This is an important point for market analysis: in the current environment, a real yield of around 1.6% remains consistent with the macroeconomic forces at work. Unless the term premium compresses significantly, it therefore seems difficult to expect a pronounced decline in US real yields.

FIG 3. Real yields: current decomposition and sensitivity to key factors⁹

Simply put, as long as demand for capital remains strong or its productivity continues to improve, real yields are unlikely to fall meaningfully.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Our global growth nowcaster was broadly unchanged, with the only weakness coming from the China signal due to deteriorating export data
   
• Our inflation indicator increased marginally this week, primarily due to a rise in the China indicator, supported by stronger production data
   
• Our global monetary policy nowcaster rose this week, driven by an increase in the eurozone signal, which shifted into a high and rising regime.

World growth nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).