What’s Really Driving Rates?

What’s moving the U.S. 10-year yield?

The U.S. yield environment has become a chessboard of conflicting forces. When reciprocal tariffs pushed U.S. average tariff rates to a century high, many expected yields to drop on slower growth expectations and a risk-off bid for Treasuries. Instead, yields moved higher, catching much of the market wrong-footed.

As a reminder, long-term yields are driven by three key factors: Inflation expectations, the path of the policy rate, and term premium (or supply and demand). All of these factors have been pressuring yields higher, though we expect the 10-year yield to get capped at 5% where we see significant demand. On the low end, we don’t expect the 10-year to fall below 3.5% given the sticky inflation environment and growing budget deficit (higher Treasury supply). Only in the event of a deep recession, where demand destruction outweighs clear price pressures, would we see a lower 10-year.

One newer factor impacting the 10-year yield is the unwinding of basis trades. A basis trade is when investors, mostly hedge funds, borrow money at low cost to buy U.S. Treasury bonds while at the same time selling Treasury futures, aiming to make money from the small difference between the two prices. Because the gap is tiny, investors engaging in basis trades use high levels of leverage to boost their profits. This method usually works well in stable markets, but if borrowing gets more expensive or banks pull back, these funds have to unwind their positions quickly, which can cause sharp moves in the bond market, similar to what we saw in markets last week.

Portfolio strategy

Strong upward moves in rates this week may have contributed to the administration’s unwinding of some reciprocal tariffs – we may never know. Lower tariffs on many countries may alleviate some inflationary pressures by giving businesses a way to maintain global supply chains. But, as we shared on Wednesday, very little has fundamentally changed for the investment outlook.  Tariff levels are still higher than they’ve been in 100 years, and U.S. companies have little capacity to bring production home in the near term. In 10-year yield terms: inflationary pressures are still solidly to the upside; demand for U.S. Treasuries may be waning at the margin.

For this reason, we hold firmly that duration is not an attractive place to take risk. We believe the U.S. 10-year Treasury yield will fill the space between the 3.5% - 5.0% range we shared above.