U.S. Treasury yields rise as term premiums and foreign holdings shift

U.S. Treasury yields are increasingly driven by rising term premiums rather than shifts in Federal Reserve interest rate expectations or inflation forecasts. According to the ACM model developed by the Federal Reserve Bank of New York, approximately 34.1 basis points of the 40-basis-point increase in 10-year Treasury yields over the past year can be attributed to the term premium. This indicates that investors are demanding higher compensation for holding long-term debt due to heightened uncertainty regarding inflation, fiscal policy, and debt supply.

Concurrently, foreign holdings of U.S. Treasuries are experiencing significant shifts. China’s holdings have reached their lowest level in 18 years, while Japan’s holdings fell to $1.116 trillion in June. Net foreign purchases of U.S. Treasuries and agency debt fell to $16.6 billion in June, the lowest level since January. While demand for Treasuries has weakened, foreign investment in U.S. equities reached a record $144.7 billion in June, suggesting a rotation of capital within U.S. assets rather than a total withdrawal.

The U.S. Treasury Department estimates net borrowing needs of $739 billion for the third quarter and $628 billion for the fourth quarter. To manage supply pressure, the Treasury has been utilizing short-term bills to finance much of the current demand, which has temporarily mitigated immediate pressure on the long-term bond market.