Fiscal Math for Today’s Challenging Bond Market

On September 15, the 10-year Treasury yield crossed 5% for the first time since July 2007. The following afternoon, in a unanimous vote, the U.S. Federal Reserve’s (Fed) Open Market Committee raised the Fed Funds rate by 25 basis points, to a range of 3.75%–4.00%.

Fed Chair Kevin Warsh was unambiguous about the reasoning behind the change in Fed policy:

“We aim to ensure that credit and financial conditions are consistent over time with our mandate, that relative price changes in some sectors of the economy do not broaden, that inflation compensation in market prices stays low, and that inflation expectations remain well-anchored.” – Fed Chairman Kevin Warsh, press conference transcript, September 16, 2026

Bond prices have been moving lower as bond yields have risen, largely because of more restrictive monetary policy and elevated inflation driven by the surge in energy prices. There’s also been a supply/demand imbalance for longer-duration assets that has resulted, at least in part, from an increase in the supply of long-term debt issuance. Other factors, such as tariffs and rising term premiums, may also have played some role in the increase in bond yields.

The Fed’s more restrictive monetary policy has led the front end of the yield curve to reprice higher, offering a positive real rate of return relative to inflation for short-term bond holders. Conversely, the long end of the yield curve is much less sensitive to Fed policy. It is governed by a number of variables, with the balance between supply and demand for long-duration bonds being a primary factor.  

While the federal deficit is widely cited as influencing the recent increase in long-term interest rates, the budget deficit has not moved meaningfully from trend over recent months. Meanwhile, energy prices, Fed policy and corporate debt issuance have all changed considerably. These are the forces that seem to have been the most impactful on the bond market.

Inflation, AI and fiscal math

Inflation and Fed policy

September headline inflation in the U.S. was up 3.7% year-over-year, well above the Fed’s target rate of 2%, driven primarily by rising energy prices. In September, overall energy prices were up 20.4% over the trailing 12 months, with gasoline prices rising 34.2% for the same period.

As noted by Fed Chair Warsh, while the Fed cannot affect the price of oil or groceries, the central bank is focusing its efforts on trying to ensure that changes in energy prices and the subsequent inflationary impact don’t produce second- and third-order effects across the economy that might cause inflation expectations to rise.

Inflation expectations are a key variable in determining how the bond market ultimately prices intermediate- and long-term bonds. September’s inflation report, with headline CPI at 3.7% and core CPI (excluding food and energy) at 2.6%, seems to be viewed largely as a pass-through of the current energy shock, not as a regime change that carries information about the level of inflation expected in 2030. This view seems to have informed Warsh’s framing of the Fed’s action at the September meeting. Rather than trying to lower the price of oil, which is largely out of its control, the Fed is aiming to prevent this oil price shock from migrating into wage- and price-setting decision making that could result in a resetting of inflation expectations.

AI infrastructure and the corporate debt supply shock

The U.S. Treasury is not the only borrower issuing long-duration debt capital at scale. Corporate borrowing to fund AI infrastructure has become a significant competitor to Treasury bonds for fixed income capital. According to research from the Federal Reserve Bank of Dallas, the scale of the capital that will be needed to fund data center development is somewhere between $3 trillion to $5 trillion over the next three to five years.

While AI hyperscalers funded much of their early data center development from cash flow, the scale of this investment has led them to turn to debt markets to continue the infrastructure build-out. Between 2020 and 2024, these companies issued an average of roughly $28 billion in debt annually, which ballooned to approximately $120 billion in 2025. Issuance in the first half of 2026 has already exceeded the total amount of debt issued in 2025. It’s estimated that investment-grade debt issuance related to AI will be roughly $300 billion in 2026, which is about one-eighth of the supply of long-dated bonds issued by the U.S. Treasury.¹

A distinguishing feature of AI-related debt is that the borrowers are largely insensitive to price. Hyperscalers are willing to pay prevailing rates because they believe that the cost of underinvesting is existential, making the decision to raise capital in debt markets strategic rather than financial. Thus, a repricing of debt to higher yields may do little to curtail continued issuance by the hyperscalers, at least in the short run.

The federal deficit

Since the Bretton Woods Agreement in 1944, the U.S. dollar has served as the global reserve currency, and U.S. Treasuries have acted as the world's default safe-haven asset. For the U.S., this has resulted in a fiscal advantage relative to other countries. U.S. Treasuries have typically traded at a premium to other debt instruments, decreasing the cost of borrowing for the U.S government. For investors, Treasuries have served as a place to park capital during periods of market stress and uncertainty, functioning as a highly liquid and inexpensive tool with which to hedge equity market risk.

Currently, the U.S. is running an annual budget deficit of roughly 6% of GDP. As the deficit continues to grow, refinancing this debt is becoming more expensive as low-coupon Treasuries issued in the 2010s begin to mature, and the debt is rolled into new bonds at the current – and higher – market interest rates. This means that interest costs will continue to build mechanically even if rates go nowhere. All of this happens automatically. Even if interest rates don’t increase further, interest expense on the debt will keep climbing. Every dollar spent servicing the debt is a dollar that can’t be spent on anything else. And unlike discretionary spending, interest costs can’t be reduced or delayed.

This is a feedback loop that will impact the future of fiscal policy. Deficits cause the government to issue Treasuries and, as supply begins to outstrip demand, the increasing supply of Treasuries raises interest costs unless demand for these Treasuries increases at the same rate. This dynamic increases interest costs and raises the deficit even further. The Congressional Budget Office projects that this loop will carry the deficit from 5.8% of GDP today to 6.7% by 2036, with a significant part of this fiscal deterioration coming from net interest costs rather than from program spending.

It’s important to keep in mind that the fiscal deficit is a slow-moving problem, and one that markets have recognized for a long period of time. As such, it’s unlikely that the current environment of rising interest rates is due to budget concerns. But given the high level of awareness, the deficit may have had some marginal impact on asset prices.

Conclusion

Events such as inflationary energy shocks, unprecedented corporate borrowing, and the impacts of monetary policy move over relatively short timeframes.

Being right about the direction of policy and being right about the timing and expression of a trade are different skills. Both are difficult, if not impossible, to master consistently. And getting both right at the same time is an incredibly high bar to clear.

Rather than relying on unstable forecasts, we believe that the proper portfolio management response to the current turmoil in bond markets is structural rather than tactical. Some steps investors may want to consider, depending on their individual circumstances and objectives, could include:
 

• Take advantage of higher long-term bond yields. The single-most important factor in estimating the forward returns for a bond portfolio is its starting yield. With the 10-year Treasury currently yielding over 5.0% and the 30-year Treasury yielding over 5.4%, high-quality bonds offer their most attractive returns in recent years, indicating that significant fiscal deterioration may already be priced into the bond market. Investors with long-term time horizons may wish to avoid the mistake of concentrating their bond portfolio in cash or ultra-short-term bonds and opt instead to take advantage of the higher yields on longer-dated maturities while they’re still available. For bond investors, higher starting yields generate higher levels of income, which can create a foundation for future return potential and provide a cushion to offset bond price volatility should bond yields continue to rise.
  
  
• Municipal bonds can be structurally attractive. Municipal bonds have been repriced and are now offering highly attractive after-tax yields for investors in top tax brackets. In addition, it may be reasonable to assume that closing a fiscal gap of the magnitude now facing U.S. policymakers will ultimately require higher tax rates. For investors in top tax brackets, tax-exempt income may become even more valuable in these conditions, arguing for a core allocation to municipal bonds for these portfolios.
  
  
• Tax management and comprehensive financial planning will become even more important. If policymakers choose to fill some portion of the fiscal gap with higher revenue from taxes, current tax rates are more likely to be a floor than a ceiling for high-income investors. This scenario argues for prioritizing planning items such as estate planning, charitable gifting and Roth conversions. From a portfolio management perspective, using direct indexing to help maximize tax-loss harvesting and a deliberate approach to asset location should be emphasized when appropriate for taxable investors.
  
  
• Maintain rebalancing discipline. Investors should be prepared for a market environment with episodic bouts of volatility rather than one single event. We believe a disciplined rebalancing policy will be essential, and portfolios that are forced to sell into stressed markets will likely be punished. Maintaining adequate liquidity and flexibility is what converts a potentially portfolio-damaging bout of volatility into a rebalancing opportunity.
  
  
• Utilize alternative investments and international equities to broaden portfolio diversification. For suitable investors, alternative investments and private markets may offer an opportunity to further diversify portfolios by utilizing strategies such as private credit, infrastructure, private equity and hedge funds. Investors seeking further diversification may take a global approach to allocation as it pertains to both traditional equities and alternative investments.
  
  

Finally, although fiscal problems develop slowly, markets can adjust quickly. We believe that a portfolio built to withstand the adjustments while maintaining strategic focus may give investors the best opportunity to do well through a full cycle. Please contact a Corient Wealth Advisor if you’re interested in optimizing your fixed income portfolio for the challenging road ahead.

¹ Sources: “How AI Debt Financing Impacts Duration Supply and Interest Rates,” (De Vere, Ramaswamy and Searls); and How Worried Should We Be About AI Debt? | Chicago Booth Review

ABOUT THE AUTHOR