• AI momentum and a constructive domestic economic outlook have supported risk assets and accommodative financial conditions. This has occurred alongside longer-term bond yields approaching multi-year highs.
• A key question for markets is whether higher yields reflect the economy undergoing a positive structural shift in growth and productivity or are being driven by other factors.
• AI is likely contributing to the repricing, though the sustainability and timing of AI’s supply and demand effects carry different implications for markets.
AI tailwinds and a constructive growth outlook continue to support risk assets and financial conditions. On growth, the Atlanta Fed’s GDPNow measure is tracking real Q3 growth of roughly 4% on a seasonally adjusted-annualized basis. AI spending can be seen through its contribution to the non-residential fixed investment component of GDP. Higher-frequency survey measures like service and manufacturing PMIs are also solidly in expansionary territory. The labor market appears to be consistent with healthy growth, though not exerting upward pressure on inflation
This backdrop has served to push equity indices to near all-time highs, compress high-yield credit spreads, and keep measures of expected equity and interest rate uncertainty contained. The broad dollar index has been relatively steady despite continued deficit concerns and shifts in trade policy, though it has recently reversed the appreciation seen earlier in the year.
Notably, easing financial conditions and resilient growth have coincided with real interest rates across the curve moving higher. Real rates reflect the inflation-adjusted return required by savers and investors, and the real cost of capital for investment. As such, this increase would typically be expected to tighten financial conditions and weigh on valuations. That has not been the case this year, though, with resilient growth offsetting the tightening typically expected.
Before moving into real yields, it is helpful to review the general framework for decomposing changes in nominal interest rates. The nominal rate contains a ‘real’ and an ‘inflation’ component. The real component largely reflects market expectations for the inflation-adjusted path of monetary policy – with the remaining components compensating investors for holding duration and inflation risk, commonly referred to as term premia.
Since the beginning of the year, nominal 10-year Treasury yields have risen by around 50 bps, with the majority of the change coming in the real component rather than inflation compensation. Has this come from a reassessment of the path for short-term yields or term premia? One useful measure to estimate this is the Adrian, Crump, and Moench (ACM) 10-year Risk-Neutral Yield. The 10-year ACM measure tries to capture what part of the nominal 10-year Treasury yield reflects the market’s expected average short-term interest rate path over a 10-year window, independent of term premia effects.
The ACM measure has risen by roughly 40–50 bps this year, suggesting that most of the increase in 10-year Treasury yields has been driven by a reassessment of the expected path of future short-term interest rates rather than by higher term premia. The key question for markets is whether this repricing is cyclical or structural. Has it coincided with an AI demand boom that is expected to fade, or does it reflect a more fundamental shift in expectations in the economy’s neutral rate, the real interest rate that balances the supply and demand for capital?
While the ACM measure does not directly measure the neutral rate, a persistent increase in the market-implied path of future short-term interest rates is consistent with markets assigning greater weight to a structurally higher neutral-rate regime. Whether this ultimately proves correct, and what is driving it, would have very different implications for asset prices.
Further complicating the analysis with respect to the AI boom is that it contains features of both a supply and demand shock with uncertain timing.
If the interpretation of the current environment is one of a cyclical demand shock that has simply pushed growth above its sustainable long-run trend, the typical Fed response would be to tighten policy by raising rates to offset this, ultimately returning expectations to the lower pre-shock equilibrium path. With the market pricing just under two 25 bps hikes by mid-2027, this would likely result in a flattening of the Treasury curve driven by higher short-term rates coinciding with realized/further priced Fed hikes restraining growth, and long-duration yields falling as some of the short-rate repricing that has pushed them higher is removed. Risk assets – equities and credit – would struggle in this case as tighter policy increases the hurdle rate for investment.
If instead, what we are experiencing is truly a structural shift in the demand for capital pushing the long-term neutral rates higher, along with a more immediate supply-enhancing productivity shift, the implications are quite different. Here, long-term yields should be embedding a structurally higher short rate, and would be unlikely to return to the levels seen during the pre-COVID years. Higher yields would then be entirely consistent with risk asset resilience, as they both reflect a regime of higher growth/productivity with less inflationary concern. It would also signal to the Fed that the initial inflationary demand shock would be offset by the supply response, reducing the urgency to tighten policy.
While it remains too early to conclude what, if anything, has raised equilibrium rates, the behavior of risk assets and higher Treasury yields suggests markets are increasingly placing some probability on this outcome. The AI investment boom and increasing use of AI technology by businesses are directionally consistent with this. If correct, higher policy rates and bond yields should be seen as a healthy reflection of a structurally stronger economy. If, on the other hand, higher yields reflect concerns around the supply and demand for Treasury securities or a questioning of the Fed’s commitment to bring inflation back to target, the current environment may not be as stable as it appears.
Not Investment Advice or an Offer -This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
