How high could the 10-year U.S Treasury yield go?

An alarming trend has developed over the past few months that has many investors concerned. U.S. Treasury yields have been climbing despite continued rate cuts from the Federal Reserve.

While there has been a recent partial reversion in this trend, the broader path appears to remain upward, with the 10-year U.S. Treasury yield moving from 0.51% in August of 2020 to a recent peak of 4.79% on January 14, 2025.

Equally as concerning is the fact that the pain from higher rates has been felt not only in bond markets but in equity markets as well. 

Since mid-December, the correlation between U.S. bonds and U.S. equities has also been on the rise. The rolling 13-week correlation between the 10-year U.S. Treasury note and the S&P 500 Index moved from a negative 0.72 on November 22, 2024, to a positive 0.39 as of January 21, 2025—indicating that prices for the two asset classes tended to move together, rather than in opposite directions, during this period.

This trend clearly is a reason for concern and has many investors wondering how much higher yields could go.

An effective way to examine the upward trend in yields and correlations is to break the 10-year yield down into its component pieces to determine what factors have been important drivers of its gradual rise.

One popular model divides a bond’s yield into two parts: inflation expectations and the “real” yield—what’s left after subtracting the expected inflation rate.

Inflation expectations can be estimated from the so-called break-even inflation rate on 10-year U.S. Treasury inflation protected securities, or TIPS. This is the difference between the current 10-year TIPS yield and the yield on regular 10-year Treasury notes. Historically, that number typically has been close to 2%—reflecting the fact that one of the Fed’s stated policy goals is to keep the inflation rate around 2% over the long term.

The break-even TIPS inflation rate was at 2.03% as recently as September 10, 2024. But since then, inflation expectations have steadily climbed. This is due in large part to fears that the Trump administration’s tariff and immigration policies could drive inflation to persistently higher levels. As a result, the break-even inflation rate rose to 2.40% as of January 21, 2025.

Real yields can be measured simply by looking at the current yield on the 10-year TIPS, which was 2.15% as of January 21. This could be considered elevated on a historical basis, as the average real yield since August 1998 has been just 1.33%. This may lead many investors to expect that real yields won’t go considerably higher from here. 

But it’s important to recognize that real yield data are historically limited, because TIPS have only been around since the late 1990s. While we do not have precise measurements from before that time, we do know that average real yields in the 1960s, ’70s, ’80s, and early ’90s probably were equal to or even higher than current levels.

Another popular model also breaks bond yields down into two separate components, but this time the two parts are Fed expectations and the term premium. This model assumes that yields reflect investor expectations for what the Fed’s key short-term policy rate, the federal funds rate, will be over the next 10 years, plus a term premium that compensates investors for the risk that rates will go considerably higher than expected.

Expectations for the fed funds rate also have been on the rise recently, as progress in reducing inflation slowed considerably during 2024. 

The expected end point for the current Fed rate-cutting cycle has been pushed up to around 4%, with the yield on the July 2026 fed funds futures contract rising from 2.69% on September 10, 2024, to 3.93% as of January 21 of this year.

The Fed’s own estimate for the long-term fed funds rate also has increased steadily over the past year, reaching 3% as of the December meeting. Markets widely expect the Fed to move its estimate even higher in 2025, so it seems reasonable to assume that Fed expectations will contribute between 3% and 4% to the 10-year Treasury yield.

There are numerous ways to estimate the term premium, including a popular methodology developed by researchers at the Federal Reserve Bank of New York. Unfortunately, this calculation shows that the term premium
is also rising and may be poised to continue that trend.

After reaching a low point of negative 1.41% during the peak of the COVID crisis, the term premium climbed to a positive 0.49% by the end of 2024. 

Unlike real yields, estimates of the term premium go all the way back to 1962, so we can better judge what it could look like in different environments. Clearly, the recent low or negative levels are outliers. The long-term average is a positive 1.48%, and the term premium has been above 1% for almost 60% of its history and above 2% for more than a third of that history. 

The bottom line is that numerous forces are pushing U.S. Treasury yields higher, including sticky inflation, ballooning budget deficits, and political uncertainty. Indeed, from a long-term historical perspective, a U.S. Treasury yield well above 5% would hardly be considered an outlier.

As a result, our Asset Allocation Committee currently holds underweight positions in both long-term U.S. Treasuries and the broader fixed income category.