U.S. Long-Term Treasury Yields Surge Despite Economic Slowdown, Raising Prospect of a ‘Higher-for-Longer New Normal’

Rising U.S. Long-Term Yields Deepen Fed Book Losses and Investor Selling Pressure
Treasury Expands Bill Issuance, Harnesses Fed Reinvestment and Stablecoin Demand
Efforts to Ease Supply-Demand Strains Intensify Refinancing Risks and Capital Concentration

The shock from surging U.S. long-term interest rates is spreading beyond the Federal Reserve’s large unrealized losses, prompting global institutional investors to reduce their exposure to U.S. Treasuries. With major overseas sovereign wealth funds considering portfolio rebalancing, long-term demand capable of absorbing rapidly expanding issuance has weakened, further increasing the U.S. government’s funding burden. The Treasury is expanding bill issuance and buybacks while seeking to establish the stablecoin market as a new source of demand, but shorter maturities inevitably entail greater refinancing risk. With economic growth concentrated in the artificial intelligence (AI) sector and distrust of fiscal and monetary policy pushing long-term rates higher, concerns are mounting that instability in the U.S. Treasury market could spill across global financial markets.

Fed’s Unrealized Portfolio Losses Reach $878 Billion

According to the Federal Reserve’s second-quarter financial report released on September 6 local time, the book value of its bond holdings stood at $6.6313 trillion at the end of June, while their fair value amounted to $5.7533 trillion. Unrealized losses reached $878.028 billion. By Treasury security category, long-term bonds recorded the largest cumulative unrealized loss at $472.431 billion. Losses on Treasury notes totaled $89 billion, while those on Treasury bills stood at $113 million.

Cumulative unrealized losses across the Fed’s Treasury holdings totaled $561.544 billion. Mortgage-backed securities (MBS) generated an additional $316.56 billion in valuation losses. The combined amount was approximately 18 times the Federal Reserve’s $47.734 billion in capital. Because the Fed is under no obligation to sell its bond holdings at market prices and can retain them until maturity, the likelihood of an immediate impairment to its solvency remains low. Nevertheless, rising long-term rates have left a substantial burden on the central bank’s balance sheet.

High Interest Rates Turn the Fed’s Earnings Structure Upside Down

The unrealized losses originated in the large-scale quantitative easing (QE) undertaken during the COVID-19 shock. The Fed purchased vast quantities of low-yielding Treasuries and MBS to support the economy, but the situation reversed when it sharply raised its policy rate after 2022 to curb inflation. Yields on newly issued bonds surged, causing the market prices of existing low-yield securities to plummet. Moreover, as of the end of June, residential MBS with remaining maturities exceeding 10 years accounted for $1.853659 trillion in face value, or 95.5% of the Fed’s total residential MBS holdings. With interest-rate-sensitive long-duration securities comprising most of the portfolio, valuation losses consequently ballooned.

This has also destabilized the Fed’s earnings structure. The average yields on its Treasury and MBS holdings remained at 2.76% and 2.20%, respectively, in the first half of the year, while the interest paid on commercial-bank reserves and reverse repurchase agreements rose far more rapidly in tandem with short-term policy rates. The Fed consequently suspended its weekly remittances to the Treasury in the fall of 2022 and began recording its accumulated losses as a “deferred asset.” A deferred asset is not a liability requiring immediate repayment but an accounting item that must be offset against the Fed’s future earnings before remittances can resume. Although profitability has moved beyond its worst phase, deferred assets still stood at $235.498 billion at the end of June, indicating that a complete normalization of Treasury remittances will take considerable time.

The interest-rate shock that inflated the Fed’s book losses has translated into realized investment losses across private bond markets. The yield on the 10-year U.S. Treasury note closed at 4.796% on September 1, while the 30-year yield stood at 5.267%. The 30-year yield climbed as high as 5.337% intraday on August 18, reaching its highest level since 2007. The longer the maturity and the greater the sensitivity to interest-rate movements, the steeper the decline in bond prices. Pressure on long-term rates is intensifying across the Treasury market’s broader supply-demand dynamics. U.S. national debt surpassed $40 trillion last month, while the Treasury’s projected net marketable borrowing for the third and fourth quarters stood at $739 billion and $628 billion, respectively.

Table 1. Key Indicators for Federal Reserve Assets and the U.S. Long-Term Treasury Market

Norway’s Sovereign Wealth Fund Considers Reducing U.S. Treasury Exposure

The greater concern is that the same interest-rate shock is accumulating outside the Federal Reserve. The Fed can hold its bonds until maturity, but institutional investors whose performance is assessed at market prices face different constraints. If they expect long-term bond prices to fall further, they are more likely to defer new purchases and redirect maturing funds into other assets.

Norway’s Government Pension Fund Global, the world’s largest sovereign wealth fund, has submitted a proposal to the government to substantially reduce its U.S. Treasury exposure. The adjustments proposed by Norges Bank Investment Management to the fund’s fixed-income benchmark are considerable. The proposal would reduce the share of government bonds in the fixed-income portfolio from the current 70% to 50% and cut the U.S. Treasury allocation from 34.1% to 21.9%. Based on the fund’s $215 billion in U.S. Treasury holdings at the end of June, approximately $80 billion would be subject to reallocation.

Norway’s move coincides with a broader shift in global investors’ perceptions of long-term U.S. government debt. Major holders, including China and Japan, have already been gradually reducing their Treasury exposure, while central banks and sovereign wealth funds worldwide have begun restructuring their portfolios in response to returns and fiscal risk. The resulting gap must be filled by private investors who are more sensitive to interest-rate movements. This means the U.S. government must offer correspondingly higher yields to absorb its enormous volume of new issuance. If selling by major institutions compounds these pressures, a vicious cycle of falling Treasury prices, rising yields, expanding valuation losses and further divestments could intensify.

Washington Seeks to Generate Treasury Demand Rather Than Reduce Debt

Under these circumstances, one available response for the U.S. Treasury is to expand bill issuance. During South Korea’s 1997 International Monetary Fund (IMF) crisis, domestic financial institutions repeatedly refinanced short-term external debt, only to be thrust into a liquidity crisis when overseas creditors refused to extend maturities. Based on the Treasury’s August financing plan, maintaining the current auction sizes for notes and bonds would require net bill issuance of $409 billion from July through September and $317 billion from October through December. In both quarters, the amount would exceed half of total net borrowing requirements. The Treasury plans to maintain its note and bond auction sizes over the next several quarters while covering seasonal and unforeseen funding needs through regular bills and cash-management bills.

Treasury bills have short maturities, limiting price volatility and attracting a deep pool of readily available demand, but they also accelerate the refinancing cycle. As of September last year, marketable U.S. Treasuries maturing within one year accounted for 33% of the total, while an estimated $9.7 trillion would need to be reissued during the current fiscal year. If the Treasury expands bill issuance, it must first secure a stable buyer base capable of absorbing the new supply arriving at each maturity. Against this backdrop, the Fed has decided that, if necessary, it will purchase Treasury bills and securities with remaining maturities of three years or less, while reinvesting MBS principal repayments into short-term Treasuries. The GENIUS Act has also broadened the scope for private-sector bill purchases by allowing stablecoin reserve assets to include Treasuries with remaining maturities of no more than 93 days.

U.S. Treasuries Emerge as a Liquidity Black Hole

Depending on the source of the funds used to purchase Treasuries, however, liquidity in other asset markets could instead contract. If the Fed reinvests MBS repayments in Treasury bills, demand for MBS reinvestment will decline by a corresponding amount. Likewise, when private investors sell existing assets to buy Treasuries, capital may flow out of other bond markets. In particular, if large volumes of high-yielding, highly secure U.S. Treasuries enter the market, investors will demand higher risk premiums on financial and corporate bonds than before. Foreign bonds, financial debt and corporate bonds would consequently face selling pressure first. If new capital allocations also tilt toward Treasuries, liquidity previously directed toward private-credit markets is likely to contract.

Because U.S. Treasury yields serve as the benchmark for dollar-denominated debt, borrowing costs for governments and companies worldwide rise as the 10-year yield approaches 5%. The UK 10-year government-bond yield has reached 5.26%, its highest level since 2008, while Japan’s 10-year yield has surpassed 3% for the first time since 1996. Rising sovereign yields have driven funding costs for lower-rated companies even higher. The spread on U.S. CCC-rated corporate debt over Treasuries has widened from 8.08 percentage points a year ago to 10.53 percentage points recently. As returns on safe assets have risen, the compensation investors demand for holding the debt of vulnerable companies has increased in tandem.

Long-Term Bond Risk Premiums Rise Amid Economic Slowdown

Moreover, the current rise in long-term rates differs in nature from previous economic expansions. During earlier expansionary periods, broad-based increases in production, income and corporate earnings gave borrowers sufficient capacity to withstand higher financing costs. Today, however, U.S. growth is slowing, while the increase in corporate investment is heavily concentrated in the AI sector. Real gross domestic product (GDP) expanded at an annualized rate of 1.5% in the second quarter, down from 2.1% in the first quarter. Although investment in equipment and intangible assets increased 9% over the latest four quarters, more than half of this year’s increase in capital expenditure came from AI infrastructure development. A handful of cash-rich AI giants can withstand high interest costs, but financial conditions in interest-rate-sensitive sectors such as housing and agriculture, as well as among lower-rated companies, are inevitably becoming more precarious.

The surge in long-term interest rates, even as the U.S. economy remains dependent on limited AI-driven growth, has been driven primarily by a higher risk premium stemming from widening fiscal deficits and instability in Treasury supply and demand. The term premium on the 10-year U.S. Treasury stood at 0.8751 percentage points on August 28, approaching 0.9 percentage points. This indicates that investors are demanding substantially greater compensation for committing their capital over an extended period. Persistent concerns over fiscal deficits and inflation, combined with large-scale bond issuance by the U.S. government and highly rated corporations, have added a premium to yields as investors question whether markets can smoothly absorb the supply of long-duration debt.

Such concerns are also eroding the “safe-asset premium” long enjoyed by U.S. Treasuries. Hanno Lustig, a professor at Stanford Graduate School of Business, said, “The advantage U.S. Treasuries have enjoyed over high-grade corporate bonds and other advanced-economy sovereign debt has weakened, while financing an annual fiscal deficit of $2 trillion is becoming increasingly dependent on capital that responds to higher interest rates.” This explains why the Treasury may be able to ease immediate supply-demand pressures on long-term securities through buybacks and increased bill issuance but will struggle to reduce the risk premium demanded by investors. Unless confidence in fiscal and monetary policy is restored, the United States is likely to face a prolonged period in which long-term rates remain stubbornly elevated even as economic growth slows.