Analysis: Higher Treasury yields deliver a reality check on a hot, inflation-prone economy

Higher Treasury yields climbed this week after stronger-than-expected economic data. The Fed's recent rate hike reinforced expectations of additional tightening. AI investment and government borrowing are competing for capital. Higher yields increase borrowing costs for consumers and the federal government alike.

The jump in Treasury yields this week is delivering a reality check about a strong economy, stubborn inflation, and the growing cost of the national debt. That will put the squeeze on the debt-heavy Trump administration as it tries to find a path forward for the economy. It also highlights the tension between the nation's top two economic policymakers. Federal Reserve Chairman Kevin Warsh wants to hear what markets are saying. Treasury Secretary Scott Bessent wants to use his tools to change the message when he believes it's wrong.

Bond yields jumped Wednesday, and were trading near multiple-decade highs Thursday, as traders digested surprisingly positive purchasing managers indices against the backdrop of a Fed that as of last week has started hiking its short-term policy rate. The 2-year Treasury yield rose 10 basis points to 4.87%, while the 10-year Treasury rose 17 basis points to 5.12% Thursday morning.

Those yields are extraordinary by recent standards but less so over a longer horizon. The 10-year Treasury averaged about 5.9% from 1990 through 2006, before years of slow growth and usually low interest rates reset Americans' expectations about borrowing costs. Now the economy looks stronger, propelled in part by a surge in investment in artificial intelligence. Competition for capital has contributed to higher interest rates.

The boom appears to go deeper. The Census Bureau reported last week that real median household income rose 2.6% to $87,460 and the poverty rate fell by half a percentage point to 10.2%. The economy's recent strength has also come on the back of a flood of government deficit spending, driven in part by large tax cuts under the first and second Trump administrations, with Iran war spending piling on. The federal deficit is set to come in above 6% of gross domestic product this year, based on data from the Congressional Budget Office. The agency projects that the tax-and-policy law passed last year will raise deficits by $4.7 trillion over 10 years, though tariffs will offset some of that.

The nation is awash in credit. Warsh pointed to heavy debt issuance by banks and other financial institutions and tight credit spreads — suggesting borrowers have little trouble seeking loans — as among the key factors that prompted him to vote with the rest of the Fed's policymakers to raise interest rates. In the days since, several other Fed officials, including Governor Michael Barr on Wednesday, said they thought more rate increases would likely be needed.

Bond yields likely benefitted from Warsh's decision to raise interest rates this week. Had Warsh not acted on inflation, traders would have run up long-term yields to account for the uncertainty of when and how the Fed might act. But Warsh will only go so far to influence the 10-year. "Ensuring continuous, sustainable, durable, economic growth, that's the business we're in," he said last week. Warsh and the Fed will act to try to tamp down the risk of inflation, but he doesn't want to induce a recession. The Fed...