Huge deficits and AI investments: what is pushing US bond yields to a peak?

On September 16, the US Federal Open Market Committee (FOMC) will convene to decide on the interest rate, which currently stands at 3.5%–3.75%.

In the weeks that have passed since the previous decision in July, market expectations have taken a turn. This time in "Data of the Week," Yaniv Bar, head of the economics department at Bank Leumi, explains what changed the trend and why the government bond market is telling a completely different story than the interest rate itself.

"Immediately after the July decision, markets priced in almost a 100% chance of a hike in September, — says Bar. — Now the expectations are around 30% for the upcoming decision." Two main factors led to the change, and both entered the picture in recent weeks.

The first is inflation in the US. The Consumer Price Index (CPI) and the Producer Price Index (PPI) indicated a moderation in the annual rate. "Overall, the picture is one of inflation beginning a process of convergence toward the target, — explains Bar, — and when these two data points join, it seems that the PCE index — the personal consumption price index, which is the preferred index for the Fed — is also expected to show a similar trend in July."

The second factor is the labor market. "The Fed, unlike the Bank of Israel for example, has a dual mandate — a commitment to inflation and also to employment," reminds Bar. The July data surprised to the downside: job additions were weaker than expectations; and while the unemployment rate did fall, it was mainly due to a decrease in the labor force participation rate. "The picture is not on the positive side, so this is another data point that significantly reduced expectations for a hike."

However, Bar emphasizes that the move is not off the table: "Markets are forecasting a full hike move by the end of 2026, and another move during 2027, and the minutes also show that some FOMC members are more or less on the same page."

AI and energy prices accelerated inflation

According to Bar, "The components that brought about the acceleration of inflation in recent months are the energy item in the CPI index, and the item concerning products related to AI investments. The energy item has moderated a bit recently, but the AI item is still in an upward trend."

Bar notes that the issue is also under examination at the Fed itself: Kevin Warsh, the new Fed chair, established several review teams upon taking office, including a team examining the effects of artificial intelligence. "In the short term, AI has inflationary effects because there is a boom and a very serious wave of investment, and therefore very high demand for components, which causes price increases. In the medium-to-long term, we expect to see a disinflationary process — not necessarily deflationary, but one that moderates price increases through efficiency, productivity improvements, and cost reductions."

Alongside this, Bar reminds that inflation risks have not disappeared: the continuation of geopolitical risks in the Middle East could reignite the energy item, and the issue of tariffs has also returned to the table.

Markets demand compensation for the long term

Here comes the unusual part. Usually, when market expectations for the interest rate path moderate, the entire yield curve drops — stronger in the short part, but also in the long part. "What we have seen in recent weeks is that the short part is indeed reacting and dropping, but the long part is not only not dropping, but even continues to rise," says Bar.

This development is reflected in the rise of the Term premium. "No one thinks the United States government will go bankrupt, but markets do demand higher compensation for holding bonds for terms of ten years or more."

Behind this demand are several factors: high government debts in major economies — in Europe, the US, and Japan — and the fear of a flood of bond supply; lack of clarity from the Fed ("in complete contrast to the previous chair, Powell, who literally took the markets by the hand" regarding his expectations, notes Bar); and new competition for savings, from companies raising debt for investments in artificial intelligence.

Another factor comes from Japan, which is undergoing a process of monetary normalization. "When you defend the currency, you sell assets in other currencies. Japan has a great many US government bonds, so it is forced to sell them — and this adds to the supply of those bonds, which is already large."

The attempt by the US Treasury to address this, by announcing an increase in buybacks in the long part, did not really work: "These are very small amounts relative to the debt volumes. We saw a reaction in the days after, and an immediate return to the trend. It's a band-aid," says Bar and adds in the bottom line, if you really want to address it, you need to signal to the public that you are going to reduce the huge deficit, which is expected to remain around 6%–7% of GDP in the coming years. However, he qualifies: "There is currently no crisis in the bond market. When you look at the yields and the term premium — this is a place we have been before."

And what about the local market? "Yields in Israel reacted to a lesser extent compared to the world and the rise in yields in the US, despite the strong correlation that exists between them," notes Bar. "This is, apparently, because of local factors, and primarily the different interest rate path."