Rising Term Premiums Push Long-Term Government Bond Yields Higher Across Major Economies

What happened?

Yields on long-dated government bonds have risen across several major economies in recent weeks, with 30-year US Treasury yields, UK gilts and Japanese government bonds all trading near multi-year highs, according to data from the respective debt management offices and central banks. The moves have been driven less by near-term inflation expectations, which have moderated somewhat according to surveys tracked by the major central banks, than by what strategists describe as a rising term premium: the extra compensation investors require to hold longer-dated debt given uncertainty about future fiscal paths, inflation and interest rate policy.

The rise has renewed attention on debt sustainability debates in Washington, London and Tokyo, all of which face persistent budget deficits that show few signs of narrowing significantly in the near term according to projections from bodies including the Congressional Budget Office and the UK's Office for Budget Responsibility.

Key points

• 30-year Treasury, gilt and Japanese government bond yields have all risen to multi-year highs in recent weeks.
• Strategists attribute the move primarily to a rising term premium rather than near-term inflation expectations.
• The US Congressional Budget Office projects persistent federal deficits averaging around 6% of GDP over the coming decade.
• The UK's Office for Budget Responsibility has flagged debt-interest costs as a growing share of public spending.
• The Bank of Japan's gradual withdrawal from bond-buying has removed a major source of demand for Japanese government debt.

What we know

In the United States, the Congressional Budget Office's most recent long-term budget outlook projects federal deficits averaging close to 6% of GDP over the next decade, driven by rising mandatory spending on entitlement programmes and higher net interest costs as previously low-rate debt rolls over into higher-yielding issuance. Net interest payments on federal debt have already surpassed defence spending in recent budget years, according to Treasury Department data, a milestone that has drawn attention from both fiscal conservatives and market participants concerned about the sustainability of current borrowing trends.

In the United Kingdom, the Office for Budget Responsibility has similarly flagged rising debt-interest costs as a constraint on fiscal flexibility, while in Japan, the Bank of Japan's gradual unwinding of its long-standing bond-buying and yield-curve-control programmes has removed a significant, price-insensitive buyer from the market for Japanese government bonds, a shift that has coincided with a rise in yields to levels not seen in over a decade.

Background

For much of the 2010s and into the early 2020s, government bond yields across major developed economies were held down by a combination of central bank asset purchases, subdued inflation, and strong demand from pension funds, insurers and foreign central banks seeking safe, liquid assets. That environment allowed governments to run persistent deficits without facing significant market pushback in the form of higher borrowing costs.

The post-pandemic surge in inflation and the subsequent interest rate increases by major central banks reset that dynamic. Central banks have since either ended or substantially scaled back their bond-buying programmes, removing a key source of price-insensitive demand just as government borrowing needs have remained elevated, driven by ageing populations, higher defence spending commitments in several countries, and the fiscal costs of energy transition and industrial policy initiatives launched in recent years.

Detailed analysis

The concept of term premium refers to the additional yield investors demand for holding longer-dated bonds beyond what would be justified purely by expectations for the average path of short-term interest rates. A rising term premium suggests investors are becoming more concerned about risks specific to holding debt for longer periods, including the possibility of higher-than-expected inflation, greater fiscal slippage, or simply increased uncertainty about future policy. Estimates of the term premium published by the Federal Reserve Bank of New York have shown a marked increase over the past two years after spending much of the previous decade in negative territory.

Several factors appear to be contributing to the rise. First, the sheer volume of government bond issuance needed to fund persistent deficits has increased, and markets need to absorb that supply at prices that clear, which some analysts describe using the basic economics of supply and demand: more bonds outstanding, all else equal, should require somewhat higher yields to find buyers. Second, foreign demand for US Treasuries and other developed-market government debt, historically a stabilising source of demand, has shown signs of softening in some periods, according to Treasury International Capital data, as some large holders diversify reserves or reduce exposure amid broader geopolitical tensions. Third, political uncertainty around fiscal policy in several countries, including debates over tax and spending plans, has added to investor unease about the credibility of medium-term deficit reduction plans.

Higher long-term yields also have second-order effects that can complicate fiscal positions further. As governments refinance maturing debt at higher rates, average borrowing costs across the entire stock of outstanding debt rise over time, a dynamic that is particularly pronounced in countries like Japan and the UK that carry very high overall debt-to-GDP ratios relative to historical norms.

Why it matters

Long-term government bond yields serve as a benchmark for a wide range of other borrowing costs, including corporate bonds, mortgages and other consumer credit, so a sustained rise tends to tighten financial conditions across the broader economy even without further central bank rate increases. Higher mortgage rates in particular have been cited by housing market analysts in the US and UK as a factor weighing on home sales and construction activity.

For governments, higher borrowing costs mean a larger share of tax revenue must go toward servicing existing debt rather than funding public services or new investment, a dynamic that can create difficult political trade-offs, particularly for governments already facing pressure to address other spending priorities such as healthcare, defence and infrastructure.

What happens next?

Investors will be watching upcoming government bond auctions closely for signs of weak demand, which could push yields higher still, as well as forthcoming fiscal announcements in the US, UK and Japan that could either reassure or further unsettle markets about deficit trajectories. Central banks, for their part, have generally signalled they do not intend to intervene directly to cap long-term yields, having moved away from yield-curve-control style policies, though the Bank of Japan in particular has said it will monitor market functioning closely.

Ratings agencies including Moody's, S&P Global and Fitch have all issued commentary in recent periods flagging fiscal trajectories in major economies as a factor in their sovereign credit assessments, and further ratings actions, whether affirmations or changes, are likely to be a focal point for markets in the months ahead.

Insight Media Opinion

The rise in term premiums across major bond markets is best understood as investors slowly recalibrating a set of assumptions that had, for over a decade, understated the true cost of persistent government borrowing. That recalibration was probably overdue, and it is a healthier long-term outcome than a market that continued to ignore fiscal fundamentals indefinitely. But the transition carries real costs, and governments that have grown accustomed to financing deficits cheaply now face a less forgiving environment just as demographic and geopolitical pressures are pushing spending needs higher, not lower.

Policymakers in Washington, London and Tokyo would be well served by treating rising term premiums as a market signal worth heeding rather than a temporary irritation to be waited out. Credible, gradual fiscal consolidation plans, communicated clearly and followed through on, tend to be rewarded by bond markets with lower risk premiums over time. The alternative — allowing deficits to drift while hoping markets remain patient — has historically ended in more disruptive adjustments than the gradual ones policymakers could choose to make today.