The “dark thunder” of the global bond market sell-off wave: neutral interest rates are rising, and major central banks may need to raise interest rates more aggressively

The Zhitong Finance App learned that a bond sell-off storm that has swept through the US, Japan, Germany, the UK and Australia is pushing global long-term borrowing costs to levels not seen since the financial crisis. As bond investors demand higher returns from the government, they expect economic growth to be stronger, corporate borrowing and investment to increase, and the central bank to raise interest rates further.

As summer comes to an end, the cool air of September brought another chill to the sovereign bond market this week, while traders are preparing for interest rate hikes in Japan, Europe, and possibly the US over the next three weeks.

An important driver for the sharp rise in global bond yields: rising neutral interest rates

The yield on US 10-year Treasury bonds, which are more sensitive to the economic situation, rose to the highest level since President Trump returned to the White House early last year. The yield on Japan's 10-year treasury bonds surpassed 3% for the first time since 1996, and the yield on German 10-year treasury bonds also hit a new high in 15 years. The yield on British 30-year treasury bonds reached the highest level since 1998, and the yield on French 30-year treasury bonds soared to the highest point in 18 years.

But as many economists have pointed out in recent months, these yield breakdowns suggest that the latest trend is at least partly driven by “actual”, inflation-adjusted yields, rather than inflation expectations themselves, nor more vague “term premiums” reflecting debt burdens or compensation for long-term inflationary uncertainty.

The US 10-year real interest rate rose by about 40 basis points in just three months and soared again in the past week. Over the same period, Japan's 10-year real interest rate almost tripled to 0.9%, while France's 10-year real interest rate was among the highest since the Eurozone era.

Regardless of the exact value, the “neutral” interest rates that have brought these economies into balance seem to be being raised — this may not necessarily be bad news, but as central banks readjust their policies to cope with the boom in artificial intelligence-related investments and seek to re-impact the economy, this shift could significantly raise borrowing costs over the next few years.

Federal Reserve Chairman Kevin Walsh appeared to have acknowledged this at the Jackson Hole meeting last week. In his keynote address, he emphasized many times that the current US monetary policy shows little or no sign that it will curb loan or credit growth, and that the financial environment is still relaxed. Walsh insisted that unless the inflation rate falls sharply back to the target level of 2% — which is unlikely to happen before the September 16 meeting — the Federal Reserve “still has a lot of work to do.”

“It's hard for me to describe the overall financial situation as restrictive,” he said at the annual seminar in Wyoming last Friday.

Fed futures responded quickly to signals, showing that the probability that the Fed will raise interest rates this month is close to 70%, compared to only one-third before. Perhaps most importantly, the market has fully absorbed the expectations of two interest rate hikes before March next year, and it is expected that the third rate hike within the next 12 months will also reach half. The policy interest rate (currently the median value of 3.625%) will not fall below 4% during the next 2-year futures contract period until 2028.

This week, due to renewed tension in the war situation in Iran, global crude oil prices returned above $90 per barrel, which undoubtedly worsened the situation. But apparently, it's not just about oil.

AI is driving economic growth, and the Federal Reserve may reassess neutral interest rates or push for further rate hikes

Walsh's remarkable speech as chairman explained how policies affect the economy because it challenged the long-held assumption by many Federal Reserve officials that interest rates were still slightly “tight.” If the Federal Reserve reconsiders “neutral” interest rates that neither stimulate nor drag down the economy, then interest rates will almost certainly be higher than current levels, and the market may adjust its “real interest rate” expectations accordingly.

The long-term nominal policy interest rate predicted by the Federal Reserve's quarterly policymakers is 3.1%, which is widely regarded as a “neutral” representative. However, this assessment is likely to change substantially: the interest rate has risen from 2.4% in 2022 to 3.8% in 2015. The Federal Reserve model suggests an actual neutral interest rate (“R*”) between 1.0% and 1.65%. Adding the 2% inflation target means that the neutral nominal interest rate will be close to the current interest rate, at the upper end of this range.

But since the Federal Reserve's actual policy interest rate (measured by the current rate of overall personal consumption expenditure inflation) is still close to zero, the Federal Reserve does not seem to be tightening the economy in any substantial way — if anything, it is likely that it is still stimulating economic growth, even though AI-stimulated growth, inflation, investment, and financial conditions all suggest otherwise.

Chip giant Nvidia (NVDA.US) said last week that there are signs that the AI capital spending boom will continue until at least next year, and its sales are expected to increase by 70% by 2028. This suggests that the nature of the global economy may be changing, forcing people to re-examine the neutral interest rate model. At the very least, corporate borrowing is rising sharply, and the US-centered data center boom is likely to spread beyond the US in the next few years.

Even if you are optimistic that increased productivity will drive the economy to grow faster, the construction and investment phase will also drive up the cost of capital by rebalancing savings and investment. Walsh himself agreed with this. He compared the current boom to a period of stagnation caused by excess savings, when no one wanted to invest and interest rates fell to zero.

For example, despite the US trade war continuing for a year, the AI race is still boosting global economic activity, as the Organization for Economic Cooperation and Development (OECD) is an example. Last week, the G20 said that the growth rate of goods trade accelerated in the second quarter. The quarterly import growth rate rose to 6.7% from 5.2% in the first quarter, with AI-related chips and computing equipment being the main drivers of growth.

It is likely that all major central banks were in the same predicament as the RBA at the beginning of the year, when it acted quickly to correct policy direction. It lost track of the trend of neutral interest rates for a while, but given other economic indicators, it knew that interest rates had previously been low. Since then, its mission has been to continuously raise interest rates and move forward in the dark, moving towards neutrality — this judgment itself may also change over time. It actually admits that you probably only really understand it when you're in it. The Federal Reserve and other major central banks are probably drawing the same conclusion.