10-Year Treasury Yield at 5% Puts Risk Assets on Notice

Executive Summary

The bond market has entered a more dangerous phase. The 10-year Treasury yield’s return to 5% is increasing borrowing costs throughout the economy and challenging the favorable valuations assigned to stocks, corporate bonds and other risk assets. Strong corporate earnings provide an important buffer, but persistently elevated real rates are a form of financial stress that investors cannot easily diversify.

5% Is a Milestone, Not a Breaking Point

The 10-year Treasury yield briefly climbed above 5% Monday, reaching its highest level since October 2023 as rising oil prices and persistent inflation increased expectations that the Federal Reserve will raise the federal funds rate, with a nearly 90% probability of a hike today.

The 5% level is a significant psychological threshold, but it is not necessarily a breaking point. The market approached that level in 2023 without producing a systemic crisis. A 5% yield is also only about 50 basis points above the upper end of the 4% to 4.5% range that could be considered neutral under current economic conditions.

Inflation above 3% and a federal deficit approaching 6% of GDP justify some concession above that range. Investors need to be compensated for the uncertainty surrounding inflation, Treasury issuance, and the long-term fiscal outlook.

The larger risk is that holding above 5% brings 6% into view. A move from 5% to 6% would represent a much more forceful tightening of financial conditions, placing additional pressure on mortgages, commercial real estate, leveraged companies and equity valuations.

The 10-year yield last traded near 6% in 2000, when real yields approached 4%. The economy has functioned with yields at those levels before, but today’s larger debt burden and greater refinancing requirements could make the adjustment considerably more disruptive.

Real Rates Drive the Selloff

The recent increase in nominal yields reflects pressure from both real rates and inflation expectations. The 10-year real yield has moved to approximately 2.6%, while the 10-year breakeven inflation rate has climbed to about 2.4%.

Real yields remain the main driver. Higher inflation-adjusted rates raise the cost of capital, reduce the present value of future corporate earnings and make risk-free securities more competitive with equities. Companies approaching debt maturities face another challenge as obligations issued during the low-rate era must be refinanced at materially higher yields.

Inflation expectations have also started contributing. The producer price index rose 0.4% in August and 5.4% from a year earlier. Final-demand energy prices increased 4.2% during the month, including a 24.1% jump in diesel fuel prices.

Oil’s move above $100 per barrel has further complicated the outlook. Higher energy costs threaten to slow progress on inflation and could delay—or reverse—expectations for looser monetary policy. Historically low unemployment claims reinforce the view that economic activity may be strong enough to withstand Fed tightening.

Market pricing is reflecting that possibility. The two-year Treasury’s yield advantage over the federal funds rate has approached 90 basis points, above the approximately 75-basis-point level that has often preceded rate increases. The five-year sector has also shed its earlier richness relative to two- and 10-year securities, while long-dated SOFR swap rates above 4.5% signal expectations for a higher path of overnight rates.

Buybacks Cannot Change the Fed Path

Treasury Secretary Scott Bessent has attempted to improve market liquidity and stem the rise in long-dated Treasury yields by increasing purchases of older, less-liquid government securities. Treasury offered to buy as much as $6 billion of securities maturing in 10 to 20 years, tripling the maximum size of its previous long-dated operation.

The market’s response was telling. Rather than declining, Treasury yields rose after the announcement. SOFR swap rates also increased, showing that investors were responding to more than Treasury supply or market liquidity.

Buybacks can improve trading conditions and make Treasury securities richer relative to swaps. They cannot, however, alter the market’s expected path for the federal funds rate. SOFR swaps reflect expectations for future overnight borrowing costs, which ultimately depend on inflation, economic growth, and Fed policy.

Fiscal Policy Adds to the Risk Premium

Fiscal policy is another concern. President Donald Trump has proposed a $5,000 payment to every adult U.S. citizen if Republicans retain congressional control in the midterm elections. The proposal would require congressional authorization and could cost about $1.2 trillion.

Whether the proposal advances, the prospect of additional deficit-financed spending is unwelcome for long-term bonds when investors are already focused on heavy Treasury issuance.

Corporate credit remains orderly, supported by strong earnings and investor demand for higher all-in yields. Yet narrow spreads provide limited protection against another rise in government rates.

The pressure could ease if inflation cools and markets begin pricing rate cuts in 2027. For now, however, long-term yields may continue rising until the Fed tightens, fiscal policy becomes more restrained, or higher borrowing costs expose a vulnerable part of the financial system.

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