Inflation Is Sending Bond Yields Higher Again. Here’s Why We’re Not Worried

Bond yields had dropped for over a month starting in early October, providing much relief to bond investors walloped by the increase in yields in the first nine months of 2026. Recall that rising yields equate to falling bond prices, and vice versa.

But now yields are rising again. A nasty inflation surprise in the latest Consumer Price Index data released this week has led to heightened expectations of interest rate hikes from the Federal Reserve.

However, we remain optimistic about inflation coming down. And we believe that a slackening of artificial intelligence’s demand-side boost to the economy will ultimately push interest rates downward in 2027 and 2028, benefiting bond investors.

What’s Happened With Bond Yields in 2026?

Bond yields have soared in 2026, with the two-year Treasury yield climbing by over 1.2 percentage points, to over 4.7% as of Nov. 11 from about 3.5% at the start of the year.

We’ve argued that the main force pushing bond yields higher has been the AI boom. The data center buildout is devouring capital, and AI spending and the concomitant uplift to stock prices are providing a broad demand-side boost to the economy. All of that has pushed interest rates up.

That’s not to say that other factors have played no role. Starting in mid-September, government debt worries helped push up yields for several weeks. That coincided with the spread between 10-year and two-year Treasury yields expanding by about 0.3 percentage points, which is what you expect given that debt sustainability is more of a long-term issue.

But the key role of AI asserted itself again starting in early October—this time on the downside. Disappointing hyperscaler earnings, along with a spotlight on the financial vulnerability of neocloud companies, triggered a cascade of worries that future AI spending would fall short of expectations. This showed up in declining stock prices in the tech sector, and it showed up in falling bond yields, validating our thesis about AI’s importance in driving the rise in bond yields in the first nine months of 2026.

The Democrats’ midterm wins provoked fears of restrictions on data center construction, leading to a further drop in bond yields in the days following the election.

From their recent peaks, the two-year and 10-year Treasury yields had fallen around half a percentage point by Nov. 5.

Bad Inflation Report Sends Bond Yields Higher, But We Don’t Think It Will Last

The downward trend in bond yields that started in early October ended on Nov. 10 when October CPI inflation came in higher than expected. The two-year Treasury yield jumped by around 0.2 percentage points on the day.

Yet bond market inflation expectations didn’t increase on the day, with the five-year breakeven yield (the difference between five-year Treasuries and five-year Treasury Inflation-Protected Securities) staying flat. What did happen, however, is that expectations for federal-funds rate hikes climbed.

So the market isn’t worried about inflation getting out of control. But the market is worried that keeping inflation under control will require more rate hikes than previously expected.

Inflation in the Fed’s preferred PCE Price Index is likely to stand at 3.6% year-over-year as of October, well above the 2% inflation target.

We remain optimistic that inflation is ultimately going to come down without a massive further rise in interest rates. The fading tariff and energy price impact, along with subdued wage growth and housing inflation, should help push inflation down.

The key area of uncertainty about interest rates ultimately stems from AI’s demand-side boost to the economy. If the AI boom keeps expanding, the Fed could be forced to push interest rates much higher to keep the economy from overheating.

However, we think that AI’s demand-side boost is likely to fade. Either AI generates payoff on its massive investment via mass layoffs, or the lack of payoff forces a slowing of spending growth. Either scenario would be a negative demand shock, pushing interest rates downward.