Long-term interest rates: Even the Fed can't tame them now

This is because yen-carry funds are diversified across various assets such as stocks, bonds, and real estate, limiting their impact on specific asset classes. In fact, if risk aversion intensifies in global financial markets, there is even a possibility of a temporary increase in demand for US Treasury bonds, which are classified as safe-haven assets.

The impact of known versus unknown information on financial markets is significant, and currently, the BOJ's policy is within the expected range, suggesting limited abrupt market fluctuations similar to the past.

As the US government's fiscal deficit widens, government bond issuance increases, and at the same time, the entities purchasing these bonds weaken, investors are demanding higher risk compensation (premium). This reveals a structural problem where rising long-term interest rates are difficult to curb with the Fed's interest rate policy alone. This fiscal health issue is not merely a temporary phenomenon but a major variable influencing long-term interest rate trends.

In the past, when the Fed pursued Quantitative Easing (QE), it acted as a major buyer in the market through large-scale bond purchases. However, as the Fed transitioned to Quantitative Tightening (QT) in 2024 and 2025, the situation changed dramatically. With the Fed ceasing or reducing bond purchases, private investors had to step in to meet demand, which has continuously contributed to widening the term premium on government bonds.

An increasing deficit means the government will have no choice but to issue more bonds. Amid ongoing wars and high interest costs exacerbating fiscal burdens, there is insufficient demand to absorb the increasing supply of government bonds, creating a structure where long-term rates are forced to remain high.

The main investors in US Treasury bonds have shifted significantly from central banks (China, Japan, the Fed) to the private sector. Currently, hedge fund investors account for over 60%, with overseas private funds, MMFs, banks, insurance companies, pension funds, and stablecoins becoming major buyers. Unlike central banks, these private investors are very price-sensitive and continuously demand higher premiums, which acts as upward pressure on long-term interest rates.

When considering exchange rate fluctuation risks and hedging costs, if Japanese government bond yields rise, the incentive to purchase US Treasury bonds while incurring high hedging costs diminishes. This suggests that Japan is more likely to gradually reduce its overall holding proportion rather than sell off all its US Treasury bonds, which could be an additional factor weakening demand in the US Treasury market.

The US Treasury's bond buyback program has limitations in terms of effectiveness. Buybacks involve the Treasury issuing new bonds to finance the purchase of existing bonds, which is essentially 'robbing Peter to pay Paul'. Because the issuer has to issue bonds to buy back unpopular ones, it ultimately needs to issue more bonds. While this may help manage the timing of bond issuance, it does not fundamentally solve the structural problem of increasing total government bond issuance amid market distrust due to war and inflation.

The estimated additional US Treasury bond buyback amount is approximately $14 billion per quarter, which is a minuscule portion compared to the total bond market size of $32 trillion. Given that the outstanding balance of 20- to 30-year long-term bonds is currently $5.5 trillion, even if all buybacks were allocated to long-term bonds, it would only account for 0.25% of the total issuance. Such a small scale makes it difficult to have a significant market impact, and without Fed intervention, the effect of buybacks is expected to be limited. Within the Fed, some members, such as Kevin Warsh, hold negative views on quantitative easing, unlike Chair Jerome Powell, creating uncertainty about the Fed's future role.

The behavior where interest rates were adjusted solely by central bank monetary policy nuances has changed since 2024. In 2025, even though the Federal Reserve (Fed) cut interest rates, long-term rates paradoxically rose. This contrasts with the normal situation where rates should fall if only the existing term premium is reflected. Structural factors such as fiscal risk, policy uncertainty, and government bond supply-demand imbalance are complexly interacting to delay rate declines, deepening a 'structurally high interest rate' situation beyond central bank control. This change increases the likelihood that future interest rates will be more heavily influenced by various non-monetary policy factors such as government finances, government bond supply and demand, war and inflation anxieties, and investor confidence, rather than just the central bank's benchmark rate.

Recently, foreign investors have been focusing on short-term bonds with maturities of five years or less in the domestic bond market. Conversely, there is a clear preference against ultra-long-term bonds with maturities of 10, 20, or 30 years. This is interpreted as a move to avoid the high risks associated with long-term bonds and raises concerns that demand will be insufficient compared to the anticipated increase in government bond supply next year.

This is interpreted as a measure to reflect changes in demand from major long-term bond buyers, such as insurance companies, and to alleviate the burden of rising long-term interest rates.

This supports the judgment that it is difficult to see an immediate economic collapse in the short term. However, if these high interest rates persist for a long period, the burden of rising borrowing costs for companies will intensify, leading to a greater differentiation among companies and eventually causing serious problems in the real economy.

Long-term bond investments carry very high price risk due to interest rate fluctuations. Due to the duration effect, for a 30-year bond, if interest rates rise by just 50bp (0.5%p), the bond price can fall by 8%, and a 100bp (1%p) rise can result in a 16% loss. Even if the 30-year yield looks high at 5% currently, considering the possibility of further rate increases, long-term bond investments aimed at capital gains involve high volatility. Therefore, at this point, conservative investment in short-term bonds of 3 years or less is relatively attractive from a carry (interest income) perspective.

Individual investors would benefit from focusing on short-term bonds in the second half of this year. In the first half of next year, a strategy of phased purchases of long-term bonds during periods of sharp rate increases could be considered. Research Fellow Kim Myung-sil expects war-related risks to subside and inflation to stabilize around next year, suggesting that the attractiveness of long-term bonds could increase then.