Government bond yields have moved higher across developed markets, reviving concerns that fixed income investors face another difficult period.
The usual explanations are present: geopolitical tension, firmer energy prices, sticky inflation and heavy government borrowing. But rising real yields suggest markets may also be reassessing the economy’s longer-term growth potential.
More than an inflation story
Longer-dated government bonds have come under pressure as investors demand more compensation for inflation uncertainty and fiscal risk. Central banks’ greater dependence on incoming data has also left markets to judge how long policy may need to stay restrictive, raising shorter-dated yields.
Inflation alone, however, does not fully explain the move. Real yields, which measure the return available after expected inflation, have also risen. That can happen when investors anticipate stronger growth, tighter monetary policy, an increase in the term premium, or some combination of the three.
The question is whether this is a temporary response to current risks, or a sign that assumptions formed during the low-growth, low-rate years after the global financial crisis are being revised.
Could AI be changing growth expectations?
One possible explanation is that markets are starting to allow for higher productivity from artificial intelligence. Markets often move before economic evidence becomes conclusive, so investors may be pricing a greater chance that automation and new working practices lift output per worker.
Productivity growth in many developed economies has been weak for much of the past decade, contributing to modest estimates of potential growth and very low interest rates. If AI improves efficiency across a broad range of industries, the effect could reach wages, investment and profits.
Higher productivity would allow economies to grow faster without generating the same inflationary pressure. It could also mean stronger investment demand and a higher level of interest rates consistent with stable growth.
The problem with R*
Economists call that equilibrium level the neutral real interest rate, or R*. It is the theoretical rate at which monetary policy is neither stimulating nor restricting the economy. If trend growth and productivity improve, R* could rise, giving central banks less reason to return policy rates to the lows of the 2010s.
That interpretation needs care. R* cannot be observed directly and estimates depend heavily on the model used. They are often revised as new data emerge. A rise in market real yields does not prove that the neutral rate has increased, still less that AI is the cause.
There is also a timing problem. Previous technological advances changed business models and living standards, but their effect on measured productivity was neither immediate nor evenly spread. AI may prove transformative, but forecasts remain highly uncertain.
Fiscal risk offers a less positive explanation
Not every explanation for higher real yields is positive. Large fiscal deficits, greater bond issuance and the retreat of central banks as price-insensitive buyers may all be lifting the term premium. Investors may simply require a higher return to hold long-dated debt.
That would be a different backdrop from one driven by stronger productivity. Higher yields caused by better growth could eventually support company earnings and risk assets. Higher yields caused by fiscal concern or persistent inflation would be harder for both bonds and equities to absorb.
Implications for portfolios
The repricing still supports caution on interest-rate risk. Shorter-duration bonds can help limit volatility, while shorter-dated inflation-linked bonds retain some protection against realised inflation.
Even so, parts of the curve now look more interesting, particularly around the five- to seven-year area, where investors can pick up more income without moving fully into long-dated bonds. Other measures of term premium, such as two-to-ten-year steepness, are less conclusive. The case for adding some duration is therefore a question of balance, not a firm call to extend aggressively.
The rise in real yields may be partly cyclical and partly structural. Inflation, energy prices and borrowing provide a convincing near-term explanation. Stronger productivity, higher potential growth and a higher neutral rate deserve attention too.
Investors do not need to settle that debate today, but they should be wary of assuming that the ultra-low real yields of the previous decade will return as the default setting. Longer-dated bonds may offer useful convexity in a growth shock, but timing that move remains difficult.
James Flintoft is head of investment solutions at AJ Bell. The views expressed above should not be taken as investment advice.