The bond sell-off, explained

The benchmark 10-year US Treasury yield jumped back to 5.0 per cent after the Federal Reserve's hawkish rate rise, handing heavy duration losses to portfolios around the world. Two forces drove the sell-off. Investors sharply raised their expectations for the path of the policy rate, and the term premium on government debt shot up on top of that.

Why the 10-year hit 5%

Desks that had bet on a single 'one-and-done' insurance hike were caught out by the FOMC's hawkish signals. Rate expectations moved quickly to price in several more increases stretching into 2027. More than half of the rise in the 10-year yield, however, came from a wider term premium. Investors now want more yield for holding long bonds because they worry about growing federal deficits, the Fed shrinking its balance sheet and inflation that keeps coming from the supply side.

Splitting the yield in two

The decomposition rests on models rather than direct observation. The expected path of short rates can be read from overnight index swaps and futures, and the residual between that path and the actual ten-year yield is the term premium. The New York Fed and the Fed Board each publish model-based estimates, and while they differ in level, they tend to agree on direction. When both show the premium rising alongside expected rates, the sell-off has two engines rather than one, and it is harder to reverse.

Each source of the rise carries a different message. A higher expected path says investors believe the Fed will do more. A higher premium says they are less sure of anything, including the Fed's success, the size of future deficits and the supply of bonds they will be asked to absorb. The second is the more worrying for the Treasury, because it raises the cost of every new bond it sells regardless of what the Fed does.

Where the losses land

Duration losses are simple to estimate. A ten-year note loses roughly eight per cent of its price for each percentage point rise in its yield, so even a modest move erases a year or more of coupon income. Bond funds, insurers marking assets to market and banks holding securities available for sale take the hit first. Foreign holders face the same losses, and many had already paid heavily to hedge their dollar exposure. Sell-offs of this kind also spread abroad, pushing up yields on German, British and Japanese government bonds, which tighten financial conditions far beyond America.

The Treasury feels the move most directly. Interest on the federal debt has become one of the largest items in the budget, exceeding defence spending in 2024, and as bills roll over and new notes are sold at higher yields the bill rises further, adding to the deficits that pushed the term premium up in the first place. That feedback loop is what bond investors mean when they talk about fiscal dominance.

Banks face a slower-burning version of the problem. Those holding Treasuries as liquidity buffers see the market value of those buffers fall, which does not threaten solvency while they can keep the bonds but reduces the cash they could raise quickly by selling them. That was the weakness that sank Silicon Valley Bank in 2023, and supervisors now watch unrealised losses more closely than they did then.

Everything else reprices

A 10-year yield sitting at five per cent changes the arithmetic for every other asset. High-multiple growth stocks, commercial property and leveraged buyouts all have to be valued lower to compete with a risk-free return of five per cent.

Shares with high valuations are the most exposed, because more of their value rests on profits expected far in the future, which a higher discount rate shrinks the most. Companies with steady near-term earnings and dividends lose less, and in 2022, the last year of sharply rising real yields, value stocks held up far better than growth stocks. Mortgage borrowers meet the same arithmetic, since thirty-year home loans are priced off the ten-year yield plus a spread.

History suggests such episodes can run for months. In 1994 an unexpected Fed tightening set off a bond rout that lifted the ten-year yield by more than two percentage points within the year and helped push Orange County into bankruptcy. In 2013, hints that the Fed would slow its bond purchases sent the ten-year up by more than a percentage point in a few months. Both sell-offs were driven as much by the term premium as by the policy path.

How the sell-off could end

The counterargument is that term premia can collapse as fast as they rise. In the autumn of 2023 the ten-year yield briefly touched 5 per cent, then fell back by more than a percentage point within about two months after the Treasury leaned more on bills and the Fed signalled it had finished tightening. A similar shift in issuance, a sharp fall in oil prices or signs of recession could produce the same reversal. The difference this time is that the Fed is still raising rates, which leaves less room for the expected path to fall.

The indicators to watch are the Treasury's quarterly refunding announcement in early November, the results of the next long-bond auctions, model estimates of the term premium and the tone of the Fed's next statement. This sell-off looks set to last. Investors now want five per cent to lend to Washington, and as long as deficits stay large and the Fed keeps tightening, growth stocks, property and buyout firms will probably keep losing value against Treasuries.