Bond yields had declined for over a month beginning in early October, offering significant relief to investors who had been hit hard by rising yields throughout the first nine months of 2026. Keep in mind that as yields increase, bond prices drop, and the reverse is also true.
However, yields are now climbing once more. A disappointing inflation surprise in the latest Consumer Price Index report, published this week, has fueled expectations that the Federal Reserve will implement interest rate hikes.
Despite this, we remain confident that inflation will eventually subside. We also anticipate that a reduction in the economic boost provided by artificial intelligence demand will ultimately drive interest rates lower in 2027 and 2028, which would be a positive development for bond investors.
Bond yields have surged during 2026; the two-year Treasury yield has risen by expected given that debt sustainability is primarily a long-term concern.
But the central role of AI reasserted itself starting in early October—this time pushing yields downward. Disappointing earnings from hyperscalers, combined with increased scrutiny regarding the financial stability of neocloud firms, triggered widespread anxiety that future AI spending might fail to meet expectations. This was reflected in falling tech sector stock prices and declining bond yields, which supported our thesis regarding the importance of AI in driving the rise in bond yields during the first nine months of 2026.
The Democratic Party’s midterm victories sparked fears of potential regulations on data center development, which led to a further decline in bond yields in the days following the election.
From their recent highs, both the two-year and 10-year Treasury yields had retreated by approximately half a percentage point by Nov. 5.
The downward trend in bond yields that began in early October concluded on Nov. 10, when October CPI inflation figures exceeded expectations. The two-year Treasury yield rose by about 0.2 percentage points that day.
Nevertheless, bond market inflation expectations did not rise that day, as the five-year breakeven yield—the spread between five-year Treasuries and five-year Treasury Inflation-Protected Securities—remained unchanged. Instead, what occurred was an increase in expectations for federal-funds rate hikes.
Therefore, the market is not concerned that inflation is spiraling out of control. Rather, the market is worried that maintaining control over inflation will necessitate more rate increases than previously anticipated.
Inflation, as measured by the Fed’s preferred PCE Price Index, is projected to reach 3.6% year-over-year as of October, which remains well above the 2% target.
We remain optimistic that inflation will eventually decline without requiring a massive, additional increase in interest rates. The waning impact of tariffs and energy prices, alongside moderate wage growth and cooling housing inflation, should assist in driving inflation downward.
The primary uncertainty regarding interest rates ultimately stems from the demand-side boost that AI provides to the economy. Should the AI boom continue to expand, the Federal Reserve might be compelled to raise interest rates significantly to prevent the economy from overheating.
However, we believe that the demand-side stimulus from AI is likely to diminish. Either AI will generate a return on its massive investment, or the spending will eventually taper off, slowing growth. Either outcome would represent a negative demand shock, pushing interest rates lower.
