That’s as long-term yields hit the highest levels since the Great Financial Crisis on Tuesday due to hot inflation data, lack of a deal to reopen the Strait of Hormuz, strong consumer spending, and continued resilience in the labor market.
“In our view, unsustainable fiscal dynamics are compounding with a reflation story, turning a short-term problem into a long-end selloff,” analysts wrote.
But that’s not the whole story. Economic data indicating more inflation as well as ongoing uncertainty about the Iran war preceded the bond market rout, BofA pointed out.
Plus, high inflation and resilient growth would typically lead markets to price in rate hikes from the Federal Reserve, flattening the yield curve as short-term rates rise more than long-term rates.
However, the opposite happened as the yield curve got steeper with long-term rates leading the charge higher. In fact, the 30-year yield hit 5.18% on Tuesday, the highest since 2007.
“Fiscal policy is the elephant in the room,” BofA declared, adding that worsening U.S. fiscal dynamics were a key driver of the selloff.
Meanwhile, the jump in yields in recent months is making interest payments on U.S. debt costlier. The Committee for a Responsible Federal Budget estimated this week that if rates remain about 55 basis points above Congressional Budget Office projections across the yield curve, then debt would increase by $2 trillion more over the next decade.
In addition, interest costs would grow from $970 billion in 2025, or 3.2% of GDP, to $2.5 trillion by 2036, or 5.3% of GDP. That also means debt servicing would consume 30% of federal revenue by 2036, up from 19% in 2025, according to CFRB.
So if the Fed hikes rates to rein in inflation, the bond market could factor in the spillover effects on the U.S. debt outlook.
“In an environment where Fed could potentially be on the table and become a driver of even larger fiscal deficits amid rising debt servicing costs, the long end of the curve becomes more sensitive to what should be primarily a move in short-end rates,” BofA said.
The market still has faith that the Fed is ignoring political pressure from Trump to lower rates and is instead focused on maintaining price stability, the note added.
“The question is not so much whether the Fed should hike, but rather if it will be able to do so amid political pressure shall the fundamentals really ask for it,” BofA warned.
It was a stark contrast from mid-February—just before the U.S.-Israeli war on Iran started—when a Treasury offering saw the highest demand ever in the history of 30-year auctions.
In addition to the latest auction of so-called long bonds, sales of three- and 10-year Treasuries also drew less demand than expected.
For his part, Treasury Secretary Scott Bessent insisted that the current energy shock will just be a momentary blip, though he admitted that it could take six to nine months for U.S. oil prices to come back down.
He predicted oil producers will eventually unleash a flood of supply, noting U.S. output is at record highs and the United Arab Emirates’ exit from OPEC means it won’t be limited by the cartel, while other Persian Gulf countries will “pump like crazy.”
