U.S. 10-year Treasury yields rose to 4.96% as of Thursday, their highest level since 2023 (see Figure 1). What’s driving up longer-term rates?
Fig. 1
Retracing Highs
10-Year Treasury Yields
Below, we look at a model that breaks longer-term rates into four factors: the trajectory of the Fed funds rate, expectations for real growth, expected inflation, and the term premium (see Figure 2). Importantly, yield direction depends on surprises relative to market expectations for each component.
Fig. 2
Dissecting The Drivers
Decomposing The Change In The 10-Year Treasury Yield*
Sources: Federal Reserve, D'Amico, Kim & Wei (2018), Payden Calculations
*The model breaks down the 10-year yield into three components, but we further separate the expected real short-term rates component into the nominal Fed funds path and real growth expectations.
To cut to the chase, the last time 10-year yields approached 5% in 2022-2023, the surge was driven primarily by a repricing of the Fed's expected rate path (see Figure 2, left panel). In 2026, the term premium is doing the heavy lifting, but all four factors point to continued upward pressure on yields (see Figure 2, right panel).
The first factor is the expected path of short-term interest rates. While some investors argue that the Fed funds rate doesn’t matter much for longer-term rates and that we “spend too much time talking about the Fed,” history suggests otherwise—the correlation between market pricing of the Fed funds rate 12 months ahead and longer-term rates is strong.
In fact, in the last 12 months, the 10-year yield's rise has mimicked market repricing in more rate hikes (see Figure 3). In other words, a higher expected path of short-term rates pushed up longer-term yields as well.
Fig. 3
Fed Repricing
10-Year Treasury Yields Versus Market Pricing Of Fed Funds Rate One Year Ahead
What are the risks going forward?
If the Fed hikes, markets may price in even more hikes. In fact, in the last few multi-hike cycles since 1993, the bond market has more often expected higher rates after the first hike (see Figure 4). If the Fed doesn’t hike, markets may still price in rate hikes as long as core inflation remains elevated at 3%.
Fig. 4
Start Of A Cycle
Market-Implied Fed Funds Change Over 12 Months After First Hike
Sources: Federal Reserve, Payden Calculations
So, as long as inflation is sticky, markets will likely price in more hikes, keeping yields under upward pressure.
The second factor is expected trend growth. In the last three decades, real rates have moved in accordance with trend growth (see Figure 5).
Fig. 5
Real Yield Correlation
10-Year TIPS Yields ("Real" Yield) Versus Trend Growth
Sources: Federal Reserve Bank of New York, Bloomberg
The same correlation is playing out in 2026. U.S. GDP growth surprised to the upside, with Kalshi’s recession probability falling from 36% in March to below 10% today (see Figure 6).
Fig. 6
Resilience Surprise
Kalshi Recession Probability In 2026
In turn, after adjusting for inflation and excluding the term premium component, the real rate component rose sharply to 2024 levels over the last eight months (see Figure 7).
Fig. 7
Market Growth Surprise
10-Year TIPS Yield Minus 10-Year Term Premium
Sources: Bloomberg, Federal Reserve, Payden Calculations
Going forward, market expectations for trend growth will depend on prospects for continued capex spending to drive private demand growth.
Despite skepticism, capex has only surprised to the upside as the year has progressed, and we think it will continue to do so with rapid revenue growth and hyperscaler order backlogs piling up at double-digit rates driving activity (see Figure 8).
Fig. 8
Capex Upgrade
Actual Versus Capex Forecasts And Past Forecast Upgrades Of Hyperscalers*
Sources: Bloomberg, Payden Calculations
*Amazon, Apple, Google, Meta, Microsoft, Oracle
The third factor is expected inflation. Perusing media headlines, one might assume that oil and gas prices were driving up inflation expectations and, in turn, yields. Wrong. In fact, long-run inflation breakevens have remained relatively stable in 2026. Actually, breakevens rarely move at all (see Figure 9)! In this framework, as long as markets trust that the Fed can rein in inflation, longer-term inflation expectations will remain anchored.
Fig. 9
Anchored Long-Run
10-Year Inflation Breakeven
But in the short run, inflation expectations still matter for rates through the Fed funds path, the first factor mentioned above. In 2026, professional forecasters expected inflation to moderate at the start of the year, but core PCE still hovered above 3% as of July (see Figure 10), which at least in part explains the move up in the Fed path.
Fig. 10
Surprise After Surprise
Core PCE Inflation Versus Survey Of Professional Forecasters Quarterly Forecast
Sources: Bureau of Economic Analysis, Federal Reserve Bank of Philadelphia
With tech prices still rising and services inflation likely to stay sticky, markets could be surprised again by how “sticky” inflation is, even as professional forecasters still expect faster moderation ahead, keeping yields elevated.
Finally, there’s the term premium. The term premium captures what remains after accounting for the three factors above. Watered-down forward guidance from the Fed Chair creates more uncertainty, and fiscal concerns prompt investors to demand higher compensation to hold longer-maturity Treasuries (see Figure 11).
Fig. 11
Premium Pricing
10-Year Treasury Yield Term Premium
Fiscal concerns won’t fade anytime soon because the U.S. federal government is still generating a budget deficit that’s 6% of GDP annually, roughly equivalent to annual net Treasury issuance of $2 trillion.
The much-ballyhooed buybacks alter the profile of debt issuance on the margin for debt management purposes, but not the total stock of government borrowing. Unless the government cuts spending or raises revenues, deficit reduction will be limited in the next 12 months, meaning looming fiscal concerns will keep upward pressure on the term premium.
Finally, one novel wrinkle: the surge in longer-dated AI debt issuance competes with long-maturity Treasuries for a limited pool of investors willing to hold longer-duration assets. A surge in duration supply means investors will demand more term premium to absorb the added duration risk, and more premium for the uncertainty of funding those positions over a longer horizon.
The bottom line is that a faster/higher Fed trajectory, better real trend growth, stickier inflation, and an elevated term premium have driven longer-term interest rates higher year-to-date. If our framework is a useful way to dissect interest rate drivers, yields could at least stay elevated for the next 12 months. For moves up or down from here, we will keep a close eye on the trends driving each.
The yield move is also global, not merely a U.S. one. U.K., euro area, Japan, and even Aussie 10-year yields have all moved up in 2026 (see Figure 12). After all, while inflation is carving different paths among developed economies, term premiums have been rising across the board, driven by higher rate volatility, an uncertain market environment, growing government deficits, and fears of additional debt issuance as populations age.
Fig. 12
Yield Synchrony
2026 Year-To-Date Change In 10-Year Government Bond Yields
Placing Blame,
The Payden Economics Team
© 2026 Payden & Rygel. All rights reserved.
This material reflects the firm’s current opinion and is subject to change without notice. Sources for the material contained herein are deemed reliable but cannot be guaranteed. This material is for illustrative purposes only and does not constitute investment advice or an offer to sell or buy any security. Past performance is no guarantee of future results.
This material has been approved by Payden & Rygel Global Limited which is authorised and regulated by the Financial Conduct Authority and by Payden Global SIM S.p.A. which is authorised and regulated by CONSOB.
