A Perfect Storm for U.S. Treasuries: Higher Rates on the Horizon?

A combination of shifting investor preferences, a surge in corporate bond issuance, and ongoing U.S. fiscal deficits is creating a complex environment for the U.S. Treasury market, with multiple analysts pointing to potential upward pressure on interest rates.

Shift in Japanese Investment Flows

Japanese government bond (JGB) yields have risen to their highest levels since the 1990s, making domestic bonds more attractive relative to U.S. Treasuries. The Bank of Japan (BOJ) is expected to raise its benchmark rate again in 2024, from 0.75% to 1%, which would mark the fifth rate increase since 2024. Prime Minister Sanae Takaichi is expected to increase government spending to offset higher oil prices related to the Iran war, which analysts say could add to inflationary pressures.

March saw the largest monthly inflow on record into Japanese sovereign bond funds. An asset manager launched its first Japanese bond fund in March.

"The new money that's being put to work won't be put to work overseas. It won't be going into U.S. corporate bonds. It won't be going into U.S. Treasuries. It will be going into those domestic allocations."
— Mark Dowding, CIO at BlueBay

Matt Smith, fund manager at Ruffer, noted: "Pressure is building — long-end domestic yields are rising. And the institutional framework is now 'please can you bring this money home'. We think yen strength will happen slowly, then quickly."

Japanese investors are the largest foreign holders of U.S. debt, owning approximately $1 trillion in Treasuries. For decades, low JGB yields drove these investors abroad, but the BOJ is now tightening its monetary policy as inflation rises.

Corporate Bond Issuance Creates Competition

Apollo Chief Economist Torsten Slok has indicated that growing competition from companies issuing their own bonds may lead to higher interest rates, impacting the Treasury Department's efforts to ensure demand for its debt. Wall Street estimates project that the volume of investment-grade debt to be issued this year could reach up to $2.25 trillion. This increase is partly driven by the artificial intelligence (AI) sector, with hyperscalers and related firms seeking bond market funding for investments in data centers and infrastructure.

Slok raised questions regarding the source of demand for this investment-grade paper and its potential influence on Treasury and mortgage rates. He concluded that the significant volume of fixed-income products entering the market in 2026 is likely to place upward pressure on rates and credit spreads.

U.S. Fiscal and Debt Outlook

The U.S. national debt has exceeded $38 trillion. Annual budget deficits have reached $2 trillion, with debt servicing costs at approximately $1 trillion. The federal government borrowed $601 billion during the first three months of the 2026 fiscal year, which commenced in October 2025. This figure represents a $110 billion reduction compared to the deficit in the same period the previous year, partly due to tariff revenues.

However, factors such as a potential Supreme Court decision striking down global tariffs and an expected increase in tax refunds due to new tax cuts could affect future government revenue. A stated commitment to increase defense spending could further enlarge federal budget deficits.

The Treasury Department expects to borrow $189 billion in the April-June quarter, $79 billion more than estimated in February. After adjusting for a larger-than-expected cash balance at the start of the quarter, the increase is $122 billion higher. Treasury borrowed $577 billion in Q1 and expects $671 billion in Q3. Factors influencing the change include new tax breaks from the One Big Beautiful Bill Act and refunds from tariffs struck down by the Supreme Court.

Changes in Treasury Buyer Base

Over the past decade, the composition of U.S. debt holders has shifted significantly from foreign governments, which are generally less price-sensitive, to profit-driven private investors. Geng Ngarmboonanant, a managing director at JPMorgan and former deputy chief of staff to former Treasury Secretary Janet Yellen, highlighted that foreign governments held over 40% of Treasury bonds in the early 2010s but now account for less than 15% of the overall Treasury market. This change could render the U.S. financial system more susceptible during periods of market stress.

To maintain sufficient demand among bond investors, Treasury yields must remain competitive relative to other offerings. A failure to attract enough investors increases the risk of 'fiscal dominance,' a situation where a central bank must intervene to finance widening deficits. Former Treasury Secretary Janet Yellen recently warned that the preconditions for fiscal dominance are strengthening, with debt projected to reach 150% of GDP over the next three decades.

Market Reactions

The Federal Reserve has cut rates by 175 basis points since mid-2024, but the 10-year Treasury yield has only dropped about 35 basis points, while the 30-year yield reached 5%. Recent U.S. Treasury auctions have shown weak demand: a 30-year bond sale in April yielded 5% for the first time since 2007, and two-, five-, and seven-year note auctions in March also saw weak demand.

"The bond market is not broken. It is sending a message."
— Mark Malek, Chief Investment Officer at Siebert Financial

Malek described the disconnect between Fed rate cuts and long-term yields as "unprecedented." Additional upward pressure on yields may come from corporate debt issuance by AI tech companies and expected balance sheet reduction by incoming Fed Chair Kevin Warsh.

Impact on Corporate Profits and Stock Valuations

Research Affiliates indicates that large U.S. budget deficits have become a primary factor in corporate profits and stock valuations. Chris Brightman and Alex Pickard of Research Affiliates noted that in the financialized U.S. economy, deficit spending may directly contribute to corporate profit. Much of the government's raised capital, obtained through debt sales, is distributed to consumers via entitlement payments, subsequently boosting corporate profits.

The researchers referenced the late 1990s, when the federal government briefly achieved a budget surplus due to a strong economy increasing revenue and cuts to welfare programs limiting spending. During this period, corporate profits reportedly declined.

Brightman and Pickard concluded that a return to a healthier macroeconomic environment — characterized by reduced deficit spending and increased net investment — could lead to significant drops in both corporate profits and valuation multiples, potentially triggering a financial crisis. They suggested that maintaining the current path might be seen as a more politically acceptable option until a crisis imposes discipline.