What’s Really Driving Interest Rates Up?

The September 15, 2026 front-page headline of the Financial Times proclaimed: “Ten-Year Treasury Yield Tops 5% as Inflation Fears Batter Bond Markets”. One day later, the New York Times reported that worries about inflation were the most important factor in the recent rise in bond yields, according to the majority of investment managers surveyed by Deutsche Bank.

Basic arithmetic, however, shows that the story is not as simple as, “The yield on ten-year U.S. Treasury bonds jumped from its 2026 low of 3.95% on February 27 to 5.00% on September 15 because investors concluded that inflation was going to be higher than they previously thought.” (Commentators focus especially on the ten-year Treasury yield, which closely tracks movements in home mortgage rates.)

First, some background.  In Appreciation and Interest (1896), Irving Fisher introduced the idea - now an established principle of financial economics - that a nominal interest rate (such as September 15’s 5.00% yield on ten-year Treasury bonds) consists of two components. First is the real rate, the price to borrowers for obtaining debt capital. Like other prices in the economy, it is subject to the forces of supply and demand. Second is the inflation premium, the amount of additional yield that bond buyers demand to offset the loss of purchasing power they will incur while waiting for their principal to be returned to them at maturity.

A market-based measure of the expected future rate of inflation, which would logically determine the inflation premium, exists in the form of the difference in yield (or “breakeven inflation”) between conventional US Treasury bonds and Treasury Inflation Protected Securities (TIPS). Between February 27 and September 15, the ten-year TIPS implied breakeven inflation rose by six basis points (1 basis point = 1/100 percentage point). By definition, 105 – 6 = 99 basis points of the above mentioned rise in the nominal rate from 3.95% to 5.00% is explained by an increase in the real interest rate.

On the face of it, that presents a very encouraging picture of the U.S. economic outlook. It is unlikely, though, that over such a short interval the supply/demand-determined cost of borrowing rose by nearly a full percentage point, even taking into account the mounting demand for debt capital to finance data center construction.  

Source: Bloomberg Professional Services. In the last two years inflationary expectations have remained anchored between 2.2% and 2.5%. The run-up in bond yields is almost entirely explained by an increase in real interest rates, reflecting an increasing demand for capital compared to its supply, expectations of a more restrictive monetary policy, and a higher risk premium.

More likely, the numbers can be reconciled by considering the fact that the real rate itself can be broken down into components.  The supply of, and demand for, debt capital is only part of the story. Risk also enters into the picture. Investors require additional yield as compensation for such things as the possibility that geopolitical disruption will inflict losses.  A closer look at the previously mentioned survey of investment managers reveals explanatory factors beyond the inflation fears that they rated most important.  For one thing, they cited the supply impact of “the borrowing binge by artificial intelligence companies.” In addition, the investment managers said that the causes of rising bond yields included uncertainty surrounding Fed interest rate policy and the U.S. fiscal situation, i.e., the mounting federal deficit budget. At time of this writing, part of Fed policy uncertainty has been reduced following the September 16’s Fed Funds Target Rate hike.

Concerns about government spending shocks and potential shifts in Fed’s management of short-term interest rates give rise to another component of real interest rates, the policy risk premium. This is the factor most responsible for the ten-year Treasury yield’s sharp rise over the past six months, in the view of the justifiably well-respected researcher David Rosenberg, onetime Chief Economist at Merrill Lynch.

The foregoing discussion appears to affirm that the recent rise in bond yields is primarily the result of an increase in the various factors that make up the real interest rate. Some readers, though, may contend that the inflation expectations are a larger contributor than we have suggested. To argue that the negligible 6-basis-point rise in the TIPS breakeven from March 27 to September 15 severely understates the expected future inflation rate, they could point to the monthly survey of consumer expectations conducted by Federal Reserve Board of New York (FRBNY). That source reports that the median year-ahead inflation expectation jumped by 58 basis points, from 3.00% to 3.58%, from the end of February to the end of August.

We recognize that consumers’ individual experiences with rising prices vary from the reported Consumer Price Index (CPI) figures, yet we are not persuaded by the  argument.  Since its June 2013 inception, the FRBNY inflation expectations series shows a 91% correlation with the actual CPI year-over-year change in the survey month.  This means that consumers’ perceptions of the likely future level of inflation are anchored by what has already happened, i.e., the past.

To cite one example, in June 2022 an inflation flareup drove CPI all the way up to 8.6%, the highest level in over 40 years.  Consumers thought inflation would remain extremely elevated, as their median year-ahead expected rate came in at 6.78%. At the time, the market-implied inflation expectations, the TIPS ten-year breakeven, was a fairly restrained 2.97%. It proved closer to the mark, as CPI fell to 4.0% by June 2023.

Conclusion

The sharp rise in bond yields from late February to mid-Septembers has not been paralleled or driven by a comparable rise in inflation expectations.  Over that period, the best measure of inflation expectations, determined by investors putting their capital at risk, has risen by a paltry 6 basis points.  Meanwhile, stock prices, which usually react badly to rising inflationary expectations, have also moved higher. 

This suggests that trends in both equity prices and bonds yields have reflected, at least in part, a strengthening economy that should boost corporate earnings as well as demand for debt capital. Risks of adverse developments on the fiscal and monetary sides of government policy have helped to drive bond yields higher and perhaps prevented stock prices from rising even more than they have.

Please do not hesitate to contact us to discuss what rising real yields mean for your investments and what they may say about the future trajectory of interest rates.