What’s wrong with long-end bonds?
Rising government bond yields have become the subject of alarming headlines. How serious is this, and what needs to happen to support long-end yields?
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Sovereign borrowing costs are in the news. Not just the business pages, but the front pages too. As bond investors, this is rarely a good thing - we tend to get the limelight mainly after a significant sell-off in the asset class, and today is no different. Yields have risen significantly, especially for longer-dated bonds, across the world.
But we believe there has been some misdiagnosis of the root causes - and thus necessary solutions - that brought us here. In this note, we discuss our thoughts on the drivers, the solutions, and the outlook for bonds from here.
This is not a fiscal crisis (yet)
Fiscal policy is important to bonds. Very important. But unlike some recent commentary, we don’t see any evidence the rise in yields is being driven by an increase in sovereign credit risk.
In the US, which has among the worst fiscal debt trajectories of any major economy, long-end yields are rising less than short-end yields. US treasury bonds are outperforming swaps, and international peers. US sovereign CDS[1] have fallen over recent weeks. None of the above is consistent with the explanation that rising yields are being driven by increased concern over US creditworthiness.
The cost of insuring against US treasury default is falling... it’s not increased credit risk driving yields higher
Source: Macrobond, Schroders, September 2026
This is not to be complacent about the future risks of sovereign credit risk, or saying concerns over debt dynamics are not valid. They are. Debt trajectories among developed nations variously range from the bad to the awful. We simply see very little evidence that has been a factor in recent pricing.
Moreover, the market focus on these fiscal sustainability dynamics is highly contextual – when inflation is low or moving lower, these fears can (and will) recede. When inflation is too high or policy is tightening, they quickly resurface – as now. In other words, fiscal fears tend to move either in virtuous or vicious circles.
So, if not fiscal credit risk, what is causing the recent repricing in bonds?
In our view, the true reason for the recent rise in global yields is somewhat more banal.
Combined policy is too loose to deliver sustained 2% inflation
This, in one line, is the root cause of the current weakness in bonds. Solve the inflation, and many other problems become much easier too.
The starting point is simple and well documented: global supply capacity has been hampered by various shocks, most recently in the Middle East, and private sector investment demand is exceptionally strong as generational-level investment in AI infrastructure coincides with a global manufacturing boom in “old economy” sectors, in no small part linked to a global desire to build greater defence capacity and energy security.
With this private demand backdrop, monetary and fiscal policy is too loose to sustainably deliver 2% inflation, especially in the US.
We think this combination of policy is crucial – what matters is not monetary policy in isolation, but how fiscal and monetary policy are interacting. If fiscal policy was withdrawing demand from the economy, monetary policy would be more than tight enough to hit inflation remits. But it’s not, so it’s not.
To our eyes, this explains the real importance of fiscal policy in the recent rise in yields: less about sovereign credit risk, and more about creating too much demand for the economy to cope with. The net result is above-target inflation. Without fiscal restraint, tighter monetary policy must be the balancing factor. It’s the release valve.
What needs to happen to stop long-end yields rising?
Unfortunately, we are unable to magic inflation away. As fixed income investors, our lives would be significantly easier if we could. So what are we watching for instead?
1 ) Solving the energy disruption
Excess demand, from both fiscal policy and strong private sector investment, is the bonfire on which bond fragilities are built. But the match to light it has been the energy shock since the start of the Iran war in February 2026.
A resolution to the conflict in the Middle East, allowing energy flows to normalise towards pre-war levels, would be a very significant help. Whatever the geopolitics of this conflict, from a macroeconomic viewpoint it is a pure supply-side constraint - the speed limit of growth we can have without creating above-target inflation is lower.
If this supply constraint was lessened (or better still, removed) the level of demand we would need to curtail to bring supply and demand back into balance would also be lower. In other words, less policy tightening would be needed - be that monetary, or fiscal (we come to this distinction next).
2) Restoring the Fed's 2% inflation target credibility
Even without the energy shock, inflation in underlying terms is too high in the US[2]. This is not 2022 - we would characterise underlying inflation as moderately too high, but not disastrously so - but nonetheless it is on the high side of what is consistent with a strict 2% inflation target.
New Fed Chair Kevin Warsh bought some inflation credibility at his first FOMC press conference, and then inadvertently gave it all away in his second. We believe his hawkish tone at the recent Jackson Hole forum has, in the short-term, regained some of that lost ground again.
But actions speak a lot louder than words, and in our view, true support for long-end bonds would come not simply from the Fed sounding hawkish, but actually being hawkish, by delivering tighter policy to deal with the inflation problem. Given benign wage conditions, well-anchored inflation expectations and the inflation overshoot being moderate we don’t believe an extensive hiking cycle would be needed – an "adjustment cycle" of 2-3 hikes would likely suffice.
This may sound counterintuitive: how would tighter monetary policy be positive for bonds? For shorter-dated bonds, the simple answer is it wouldn’t. Tighter Fed policy means higher yields in the 0-5y segment of the curve. But for longer-dated bonds, we believe that greater inflation fighting credibility would counteract the impact of higher short-end yields. We would expect significant flattening of the yield curve and at long-enough maturities, could even see outright yield declines as a result of tighter policy[3].
Put another way, the greatest threat to long-dated bonds is not tighter short-term policy, it is a Fed that appears uncaring about higher inflation.
At the time of writing, a hike in September is a close call, but marginally more likely than not.
3) AI boom rolls over
Part of the reason demand is outstripping supply - the cause of inflation - is the once-in-a-generation infrastructure buildout of AI infrastructure, combined with a global upswing in “old economy” capex. If this private investment demand were weaker, the current monetary/fiscal policy stance wouldn’t be a problem.
But it’s not: private investment is incredibly strong. In effect, in a reversal of how we usually use the term, it is the AI hyperscalers[4] ”crowding out” public sector borrowers- forcing sovereigns borrowers to pay higher yields in a ”competition for capital”.
If, for whatever reason, this surge in private sector investment demand[5] were to weaken, it would be a notable moment for bond markets and take significant pressure off long-end sovereign yields. Listening to our internal experts[6] however, and surveying the earnings release outlooks from companies within the AI sector, a sharp reduction in AI infrastructure capex doesn’t seem likely in the near-term. The upward trend seems strong, and possibly even strengthening.
We’d consider this a high-impact, low-probability event.
The private sector investment boom - data centres and old-economy capex
Source: Macrobond, Schroders, Aug-September 2026
Which brings us to the ultimate, long-term solution. Fiscal policy is simply, for current economic conditions, too loose. It is creating excess demand that the supply capacity of the global economy cannot currently cope with.
If policymakers desire lower bond yields, consolidating public finances would be the best and quickest way to achieve this. This could be done either via spending cuts, tax rises, or some combination of the two. As macro investors, the overall fiscal stance is far more important than the microeconomics of which lever – tax or spend – delivers it. Indeed, for different countries the optimal method of fiscal consolidation will differ.
But the simple point remains, at a global macro level, fiscal policy should be tighter given current conditions and moves to tighten would be the single most important event to contain the recent rise in government bond yields.
How likely is this? Right now, appetite for fiscal restraint seems very limited, which is problematic for bonds. But rising yields and interest burdens focus minds, and the outlook for public finances is climbing the political agenda in several countries.
But in the country with the most glaring need for fiscal consolidation – the US – we see little evidence that tightening is on the near-term horizon. In Japan, with a huge debt burden to start with, the government is moving toward stimulus. Germany did so last year. Thus, at a global level, it’s hard to have confidence we are on the cusp of noticeable fiscal restraint.
Not much fiscal consolidation in sight for the US
Source: Macrobond, Schroders, September 2026
What about treasury buybacks or Fed “yield curve control”?
The above arguments cover the main fundamental factors which could see the trend higher in long-term bond yields stabilise. But there are other policy actions that are being used, or have been suggested, to achieve the same end.
We have seen the US Treasury announce its intention to buy back some of its longer dated debt, which could be funded out of existing cash reserves or by issuing shorter dated bills. Going forward, a more powerful extension of this strategy would be to reduce issuance of longer-dated bonds to fund the deficit, with a greater share of issuance via shorter dated bonds or bills instead.
This is, to us, simply a buying time strategy. And buying time is not the worst idea as long as you are buying time for other actions to take place. If buybacks or shortening of issuance is done in isolation, it simply will not work. It is treating the symptoms, not the cause, of the illness. If the US Treasury want sustainably lower yields, they should reduce deficits.
A linked thought process has been that ultimately the Fed could do a form of yield curve control to support long-end bonds. This, in our opinion, is a nuclear option.
As we have explained in this note, long-end yields are rising to curtail demand. Yield curve control would artificially suppress these while expanding monetary growth[7], and thus not reduce demand but instead very likely increase it. It would be the literal opposite of what the Fed is trying to achieve in bringing back price stability. This isn’t so much treating the symptoms rather than the disease, this is actively making the underlying disease worse.
We rule nothing out in these volatile times, but would put very low probability of this type of intervention within our investment horizon.
Thinking long and short-term: how does this affect our portfolios
It is worth separating structural and tactical considerations here.
As the above makes clear, we remain concerned that many of the structural drivers that have driven long-term bond yields higher globally – fiscal deficits, huge AI-related capex and bond issuance, persistent above-target inflation – have not been solved. Of course, with higher starting yields, we are better compensated for these risks, but we will need more definitive proof the underlying causes are resolved before we are confident that a structural top in long-dated bond yields has been reached.
But even while these concerns about longer-term dynamics for bonds linger, significant tactical rally opportunities exist. Short-term bond sentiment is now deeply, even extremely, negative: the sheer number of media reports in recent days about multi-decade high bond yields is testament to that. Thus, the hurdle for relatively ”better” news for bonds in the short term is, in our view, low. And with the market pricing a near 50% probability of three or more hikes from the Fed, combined with our view that the inflation overshoot is mild, rather than severe, we see attractive tactical opportunities in global duration despite lingering concerns about the structural dynamics.
Finally, as is clear from the above analysis, different dynamics are affecting different parts of the sovereign bond universe. Things that are good for long-dated bonds, such as tighter central bank policy, are not good for short-dated bonds. Some countries require more fiscal restraint than others. Inflation outlooks differ by country.
The case for active management of sovereign bonds is strong: being in the wrong geography, or the wrong part of the yield curve, could be costly.
Notes:
1] CDS - a proxy for the cost of insuring against sovereign default.
2] By how much it is too high is highly dependent on your preferred metric: trimmed mean measures look slightly too high; median is a bit worse; core PCE excluding food and energy is the worst of the lot. But the consistent theme is they are too high.
3] What we call a pivot flattening, where different parts of the yield curve go in different directions.
4] Amazon, Google, Microsoft etc.
5] …and bond supply
6] August 2026: early signs of AI return on investment?
7] This is the key difference between Fed QE/yield curve control and treasury changing issuance profile: Fed actions have the ability to create money.
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