The "term premium," the extra yield investors demand for holding long-term bonds, is breaking out after years of Fed suppression. Its resurgence indicates investors are now demanding compensation for long-term inflation and sovereign risk, posing a major threat to markets reliant on cheap leverage.

Bond markets are not pricing in higher long-term inflation; expectations remain anchored near the Fed's 2% target. However, the uncertainty around future inflation has widened significantly due to shocks and policy shifts. This increased risk of volatility drives the higher "term premium" demanded by investors.

Treasury bonds act like stocks when supply-side inflationary shocks hit the economy and central banks are forced to accept recessions to fight inflation. During demand-driven shocks, falling inflation benefits nominal bonds during downturns, preserving their negative correlation with equities. Recent stability in inflation expectations combined with inertial monetary policy has kept bond risk lower than in the 1980s.

The surge in bond yields is less about inflation fears and more about basic supply and demand. Discretionary investors like hedge funds require a higher yield to absorb the ever-increasing volume of government debt, as traditional buyers like foreign central banks are no longer increasing their holdings.

If investors only feared 2% inflation but demand a 5% yield, the extra 3% is a risk premium. Lenders are charging the U.S. government more because they are less certain about its ability to repay debt with valuable dollars, signaling that the borrower—the U.S. itself—looks shakier.

The spike in long-term bond yields is overwhelmingly caused by a surge in real rates, not inflation expectations. This is driven by increased capital demand from AI-related CapEx and, more significantly, a market repricing due to a newly hawkish Federal Reserve, not a fundamental shift in the inflation outlook.

For years post-GFC, QE created a reliable negative correlation between stocks and bonds, making treasuries a positive-carry hedge. The 2022 joint drawdown, where both asset classes fell sharply, proved this relationship is broken, forcing investors to pay for explicit portfolio insurance via options.

While conventional wisdom attributes surging 10-year Treasury yields to inflation fears or fiscal profligacy, market models show inflation expectations and term premia have remained relatively flat. Instead, bond yields are rising because resilient nominal GDP growth—running above 6%—is forcing markets to reprice the Federal Reserve's long-term terminal rate substantially higher.

With inflation becoming less of a concern in 2026, bond yields will be driven more by growth expectations than inflation risk. This restores their traditional negative correlation with equities, making them a more reliable diversifier and hedge against a potential economic downturn in portfolios with long-risk exposure.