The Cure for Higher Yields May Be Higher Yields

Bond yields pushed to fresh cycle highs across the G7 this week. In some cases, they are trading at levels not seen in decades. French 10‑year yields are above 4.2%, their highest since 2008, while Japan’s 10‑year yield hit 3%, a level last seen in 1996. These are not milestones to celebrate. Rather, they mark the latest stage of a global bond bear market that has been grinding on for years. The catalyst this week appears to be energy. Oil prices surged as tensions between the US and Iran escalated. Six months into the conflict, there is little sign of a resolution.

This puts central banks on notice. Crude oil staying in the US$80–US$120 range, together with refining bottlenecks, is enough to generate inflation pressure but not enough to trigger the kind of global recession that would bring inflation down on its own. As a result, another round of global monetary tightening looks likely. The RBNZ moved first this week with a 25bp hike. We think the ECB and BoJ are set to follow later this month, and there is a meaningful chance that the Fed may ultimately hike as well—even though our own forecast is still for a hold. The Bank of Canada held rates this week, but noted that the longer high energy prices persist, the greater the risk of broad spillovers.

Looking past this week’s headlines, the bond market faces a deeper problem. Developed markets are producing debt faster than investors can digest it. Governments are running wider deficits post Covid (graph 1), and large corporations are borrowing more to invest in AI. The OECD expects governments and corporations to raise a combined USD 29 trillion from capital markets in 2026, 17% more than in 2024. Sovereign bond borrowing in OECD countries has climbed from USD 12 trillion in 2022 to USD 18 trillion in 2026. Corporate borrowing is also running at all-time highs. In short, the world is issuing bonds at a remarkable pace.

Meanwhile, demand is becoming less reliable. Central banks are no longer accumulating bonds through quantitative easing. Foreign reserve managers are less eager buyers, particularly since the freezing of Russia’s reserves. Large public pension funds now prefer to invest in higher yielding private assets like infrastructure, rather than government bonds. All that has shrunk the pool of price-insensitive buyers.

Price-sensitive buyers are reluctant to catch a falling knife. While higher yields should attract buyers, investors also care about future supply. They demand additional compensation if they expect to be on the hook for even more issuance in the future. Governments can reduce this premium by convincing markets that their borrowing needs will become more sustainable over time. Unfortunately, in most major economies, political appetite for reducing fiscal deficits is low. Germany has committed to a beefier defence budget and industrial policy. France’s minority government postponed a critical but unpopular pension reform this year, highlighting the political difficulty of fiscal restraint. In Canada, the federal government is spending more to cushion the economy from trade uncertainty and support investment in infrastructure, energy and nation-building projects. Finally, in the United States, which is the largest source of supply, there is little sign that either party is prepared to meaningfully shrink the fiscal deficit.

That leaves markets as the last line of fiscal discipline. Rising borrowing costs would increase debt-servicing burdens, squeeze fiscal room and eventually force difficult choices that politicians have been reluctant to make. In that sense, the cure for higher yields may be higher yields. But don’t expect governments to quietly accept that premise. Next week, the US Treasury will undertake its first expanded buyback operation in long-end bonds. Officially, these are a routine liquidity-support operation. But the timing leaves little doubt that policymakers are paying close attention to the bond market.