Why This Top T. Rowe Bond Manager Thinks Yields Can Keep Going Higher

Key Takeaways

• T. Rowe’s Orchard says higher bond yields aren’t temporary, thanks to inflation and big deficits.
• He says to expect central banks to raise rates but stop short of effectively tackling inflation, owing to its unpopularity.
• Higher yields mean inflation-protection bonds and a new focus on income are important.

Bond yields in the United States and many key markets are hitting their highest levels in decades. “Higher for longer” interest rates have been a mantra for many in the bond market over the last couple of years. But Kenneth Orchard, head of international fixed income for investment manager T. Rowe Price, thinks that even if the current bond market selloff is nearing its end, the longer-term trend is still higher for yields.

We spoke to Orchard, who oversees some $39 billion, about the impact that forces as wide-ranging as government deficits, El Niño, and Japanese monetary and fiscal policy are having on the bond market. Plus, he explains why he’s a fan of inflation-linked bonds, and why investors should look at the bond market through an income-focused lens.

Leslie Norton: Let’s set the table. Long-term government bond yields are popping to multi-year highs.

Kenneth Orchard: We’re in a long-term, structural period of high and gradually rising bond yields. Demographics and geopolitics have changed the world’s balance of savings and investments. People used to talk about the savings glut. We don’t have one anymore. This period is driven by the large fiscal deficits most developed countries are running. Wars, El Niño, and other things are pushing up prices.

Central banks are reluctant to tackle this persistent inflation head-on. They’re trying hard to tinker at the margins, and that isn’t preventing inflation expectations or overall growth from coming down sufficiently to get inflation down. It will be a multi-year process. In the past week, we’ve seen a breakout. I suspect we’re nearing the end of this wave of higher yields.

The Fed’s Next Move

Norton: What are the next moves for policymakers? How do the Fed and the Treasury respond? Will we have another bond repurchase?

Orchard: I don’t have a view on the bond repurchase plan, and I have serious questions about its impact. It’s small compared with the total amount of debt they’re issuing. If the Fed really wants to get long-end bond yields down, they need to hike interest rates to slow down the economy and anchor inflation expectations. The ball is firmly in the court of the Fed and central banks.

Most central banks face the same issue. We’ll see if they deliver this month. I think the Fed will hike 25-50 basis points over the next few meetings, probably enough to calm the market situation but not enough to get inflation firmly back to target. I don’t think central banks have the courage to tackle inflation. They would have to risk a recession, allow unemployment to go up. It would make them deeply unpopular.

Norton: Why do you think this wave of selling is nearly over?

Orchard: If we look at bond market technicals, this up move in yields has been since the beginning of March. The typical selloff in the last 20 years is a little bit more than this. On valuation, look at 10-year real policy rate expectations in the US. In 2023, that got up to around 2%. Currently, we’re in the 1.6%-1.7% area. The 10-year today is yielding 2.45%. We got to 2.5% in 2023.

What Japan’s Yield Spike Means for the World

Norton: Let’s talk about Japan. What does this spike in yields mean for Japan’s recovery and the global economy?

Orchard: Japan’s very interesting. For a long time, the Bank of Japan was behind the curve as inflation rose and became more persistent. The new Japanese government has been pushing a very pro-growth agenda and has been more hostile to policy rate hikes, even as the need for them increased.

What we really need is for the BOJ to get more aggressive, to show it’s serious about tightening monetary policy to slow growth and tackle inflation. They need to get their policy rate up to 2% more rapidly. They’re starting to get the message to accelerate rate hikes to three or four a year. We’re a lot less cautious on Japanese rates than previously.

Norton: What does this mean for the rest of the world?

Orchard: Japan has become a relatively small part of the global economy. I do think the rise in JGB yields does have implications for the world. Japan is one of the world’s biggest net savers. They previously exported a lot of savings. If you push up JGB yields, you raise the opportunity cost to Japanese institutions and households for sending money abroad. That’s part of the reason we’re seeing upward pressure in other bond markets.

Why Global Inflation Will Stay High

Norton: Let’s talk about your expectations for global inflation. High energy prices are especially a concern in Europe.

Orchard: The big concern in Europe is gas and the implications for electricity prices. That will put upward pressure on Eurozone inflation and the European Central Bank. The market has recently been pricing in another rate hike. That makes a lot of sense. There are three hikes priced in for the ECB in the next year, which we don’t dispute. So there’s some additional risk in intermediate yields, but [the hikes] should also start to anchor long-end euro yields.

We expect global inflation to remain persistently high. Our commodities team is generally bullish on commodities, including oil prices on a multi-year timeframe. The rapid productivity growth from 2012 to 2022 is more or less over. A lot of new, easily exploitable oil reserves in the US are starting to decline, so bringing on new ones will be more expensive than before.

In terms of agricultural commodities, a lot is going on with geopolitics, global warming, and El Niño. In metals, we’re seeing environmental standards tighten, making it more difficult to build new copper mines. That’s why copper prices are at all-time highs. Combine all these things, and we expect upward pressure on headline inflation. On core inflation, we have shrinking labor forces, which means that even with artificial intelligence, we don’t expect downward pressure on wage growth.

Norton: What does this mean for the markets?

Orchard: Inflation-linked securities have really been overlooked. People thought they added volatility to your portfolio for nothing. But inflation-linked bonds have performed well for almost 10 years. The last year US nominal Treasurys outperformed US TIPS was 2017. That’s an underappreciated statistic. We’re big fans. We own TIPS in the US, Europe, Japan, and Canada.

Norton: Let’s talk about the explosion of debt in AI-related borrowing. How real is the crowding-out phenomenon?

Orchard: Traditionally, “crowding out” applied to government borrowing, which would push up rates and reduce private sector borrowing. Today, private borrowing is very strong. The AI tech space is forecasting high ROIs. They aren’t particularly sensitive to rates.

The crowding out is happening in other parts of the private sector. The biggest place is housing. Hyperscalers are crowding out the mortgage market. With mortgage rates where they are now in the US and other countries, you’re not seeing much housing activity because affordability is not good.

Focusing on Bond Income

Norton: Where will yields find their ultimate equilibrium? What does this mean for the end investor?

Orchard: There’s higher to go because we’re not at the end of the economic cycle. Inflation’s not tamed. Central banks will likely do a bit in the next three to four months and then hope they’re done. They’ll probably have to start more rate hikes, not necessarily in 2027, but maybe in 2028 or 2029. Developed market yields are almost certainly going higher.

For the end investor, the focus should be on income. A lot of people think higher yields are a negative because you take a short-term capital loss. But pushing up the yield you receive from a bond makes fixed income much more attractive.

We recommend that people think about bonds as a way to generate more regular, stable income, rather than as insurance. If you can generate 6%-7% of income from a credit portfolio—corporate, securitized, emerging markets bonds—that’s pretty attractive versus equities over a five-year horizon, and it will come with a lot less volatility. Think about inflation-protected bonds. And think outside the typical safe havens. People think the US is the ultimate safe haven, but that’s not how things played out over the last five years. There are better investments in the medium and longer term than the US, Europe, and Britain.