Why Bond Yields Are Surging: It's Not Just About Inflation

The bond market has been sending conflicting signals lately. While long-term yields have climbed dramatically over the past months—the 10-year surged more than 100 basis points since mid-July—inflation expectations have actually cooled down. So what’s really driving this move? According to Franklin Templeton’s Chief Market Strategist Stephen H. Dover, the culprit isn’t what most investors initially thought.

The Term Premium Story

Here’s where term premium comes in. Think of it as the “price of uncertainty” that bond investors demand for lending money over longer periods. When you buy a 10-year bond instead of rolling over 2-year notes, you’re taking on more risk—rates could change, inflation could surprise you, your money is locked up longer. So investors naturally want to be compensated with higher yields.

Long-term interest rates actually consist of three distinct layers: inflation expectations, the neutral short-term rate path, and term premium. Yet the 2-year yield has only risen about 35 basis points over the same period—a stark contrast to the 10-year’s 100+ basis point jump. This disconnect tells us something crucial: the massive move in long-term rates stems primarily from rising term premium, not from inflation or bond supply concerns.

The Fed Put Is Gone

Why has the term premium expanded so dramatically? Dover points to one major structural shift: the disappearance of the “Fed put” that dominated the last decade. For years, investors enjoyed a comfort zone—whenever markets got turbulent, the Federal Reserve was there with asset purchases, rate cuts, and reassuring guidance. That implicit safety net created a false sense of security.

Now that comfort is gone. The central bank has stepped back, and investors face raw, unfiltered market volatility. This increase in uncertainty and risk for longer-duration bonds means investors rightfully demand higher compensation—hence the rising term premium.

What This Means for Markets

Higher borrowing costs ripple through the economy. Companies face steeper debt servicing expenses, households postpone major purchases, and as long as yields remain elevated, economic growth takes a hit. Simultaneously, profit margins get squeezed and risk assets like equities and credit instruments face headwinds.

Understanding this distinction—that the yield surge comes largely from term premium rather than inflation fears—changes how investors should position themselves in fixed income markets.