A short fuse on long bonds

If volatility was the main market narrative of the first half of the year, we expect the second half’s to be, well, more volatility.

Global bond markets have had to contend with issues on numerous fronts, and on all sides. Issues such as tariff-related inflationary risks have argued for higher yields, where the potential for tariff-induced slower economic growth would argue for lower yields.

Though the trade war seems to have somewhat dissipated into the background for now, tariffs remain both highly uncertain and likely to have ripple effects into the second half of the year. And as is often the case, one source of volatility is more likely than not to simply be replaced by another. The next risk for global bond markets may come from inside the building – sovereign bonds.

Lower interest rates, higher yields

The first chart below points to budding risks around government finances. While most major central banks – save for Japan – have been slicing short-term interest rates, longer-term sovereign bond yields have not only failed to follow, they have moved in the opposite direction entirely.

For example, since the Federal Reserve delivered the first of a series of rate cuts in September 2024, which ultimately amounted to 100 basis points, longer-term Treasury yields have risen by an equal amount; a similar story has played out in the UK.

While the rise in Japanese long-term yields may not be as surprising given modest rate hikes from the Bank of Japan (BoJ), much of the recent spike came on the back of unexpectedly weak investor demand at bond auctions in May. Investors seem to have stayed away amid rising concerns about Japan’s worsening fiscal trajectory.

Despite central bank rate cuts, bond yields keep rising

Fiscal focus

And therein lies what could be the next source of market volatility this year – sovereign credit fears.

Though long-term bond yields have also risen in Germany and Canada despite even deeper rate cuts from both the European Central Bank and the Bank of Canada, the more modest move higher may simply reflect fewer credit concerns.

Following Moody’s downgrade of the U.S. credit rating in May, the U.S. now holds an average credit rating of AA+, the UK is rated AA, and Japan is A+. What about Canada and Germany? Both are still rated AAA with few looming concerns on the fiscal front, in our opinion.

The UK has battled its own budget concerns in recent years as bond markets most notably pushed back forcibly on previous tax cut and deficit expansion plans in 2022. In the first quarter of this year, UK government financing needs hit one of the highest levels on record as the yield on 30-year Gilts breached 5.6 percent, the highest level since 1998.

Then there’s the United States. While fiscal deterioration is nothing new – and reasonably well-weathered by markets for decades – things risk coming to a head later this year.

One factor in Moody’s decision was the expectation that the “One Big Beautiful Bill Act” would add $4 trillion to the deficit over the next 10 years and that annual deficits would rise to around 9 percent, and that’s assuming steady economic growth and full employment. Slower growth and/or an outright economic downturn would likely only increase the deficit.

Though the final form of the bill remains to be seen, and the bias appears toward being less of a deficit buster in the Senate, we think U.S. deficits will almost certainly continue to trend in the wrong direction.

That will keep the focus on government bond auctions, and how governments plan to finance themselves. After May’s spike in yields, the BoJ has seemingly been able to calm markets by floating the idea of reducing long bond issuance levels if demand is lacking. In the U.S., the Department of the Treasury could also go down that path should there be signs that domestic and foreign interest is lacking. That could serve to help keep long-term yields lower, but there are also risks of shorter-term issuance and refinancing risks, not to mention that the department may already be overly reliant on short-term financing. There may be only bad, and not as bad options, and that could be a lingering source of volatility itself.

Economic knock-ons

Finally, market optimism might be getting ahead of itself. Global risk assets have seemingly been buoyed by central bank easing, but it may only be phantom easing.

For example, when the Fed started cutting short-term rates last September, the benchmark 10-year Treasury yield was 3.6 percent and the average 30-year mortgage rate was 6.6 percent; at the end of May, those two metrics were higher at 4.4 percent and 7.0 percent, respectively.

Despite the attempts of the Fed and other central banks to deliver policy-easing measures, those efforts may not have had the desired impact. The weight of higher sovereign bond yields – which tend to have a lagged impact – could still pose a risk to economic activity globally through the end of the year.

Risks, but paid for the risks

Global bond yields appear stuck between the threat of persistent inflation and higher debt levels on the upside, and slowing economic growth and rising unemployment on the downside.

The simple assumption would be that yields remain rangebound the rest of the year. That said, we think that a slowing growth backdrop will eventually prevail as the dominant driver of yields, and that global yields will generally trend modestly lower into the end of the year.

And if there’s an upside to swelling sovereign balance sheets, it’s that fixed income investors now have more options, and more yield. The post-global financial crisis era of subdued government spending, sluggish growth, and non-existent yield levels looks increasingly likely to be relegated to the history books. Despite risks, at least investors are now being compensated for those risks.

The era of low rates has been left behind

Bloomberg Global Aggregate Bond Index yield