The Big Idea
Real rates, not inflation, driving the US yield curve
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Demand for money rather than concern about inflation is driving the US yield curve higher. Real rates have jumped across the curve since April while implied inflation has plunged. That’s surprising considering all the analysis that draws a line from US-Iran to higher oil and inflation and then on to higher rates. But demand for money rather than concern about inflation looks like the better theory of current US rates. And the difference between the demand theory and the inflation theory is the difference between rates staying up or not.
Implied inflation down, real yields up
Inflation implied by the yield spread between Treasury notes and TIPS has dropped across the curve in recent months. Implied 5-year inflation has dropped 44 bp since the end of April, for example, implied 10-year inflation by 24 bp (Exhibit 1).
Exhibit 1: Implied inflation has broadly dropped in recent months
Source: Bloomberg, Santander US Capital Markets
Real yields on TIPS have gone up by more than enough to offset the decline in implied inflation. The real 5-year rate is up 86 bp since the end of April, the real 10-year rate up 55 bp (Exhibit 2). The net result has been a rise in nominal rates across the US curve.
Exhibit 2: TIPS Real rates have moved higher in recent months
Source: Bloomberg, Santander US Capital Markets
Theories of the market
The recent path of implied inflation seems solidly in line with the link between US-Iran and oil. Implied inflation has tracked the price of oil over most of the period, although that link has broken lately. The price of a barrel of Brent crude and West Texas Intermediate fell from April into July but has spiked up since (Exhibit 3). The latest spike does not show up in implied inflation, suggesting the market expects oil prices to reverse quickly enough to have limited impact at least on 5- or 10-year inflation.
Exhibit 3: Oil tracks with implied inflation, except for July’s oil spike
Source: Bloomberg, Santander US Capital Markets
A current theory of real rates is a little more complex and has to consider anything that might affect the supply and demand for money at different horizons.
But one thing has clearly accelerated the demand for money this year—the extraordinary rise in debt financing for technology. Among the five companies leading the AI race—Alphabet, Amazon, Meta, Microsoft and Oracle—expected capital investment this year is well beyond $656 billion, with a significant share of funding sourced from debt. Growth in outstanding investment grade debt this year through June is on track to more than double the pace and amount of 2025. The corporate market is becoming a significant source of demand for cash.
Exhibit 4: Corporate debt is competing for cash
Note: 2026 numbers annualized from 1H2026 results. Source: Bloomberg, Santander US Capital Markets
There are other things that may be adding to demand for money, but not nearly on the scale of the technology buildout for now. The same drop in oil prices that pulled implied inflation down also likely reduces the drag on broader economic growth, which also encourages more borrowing. And the US-Iran conflict, increasingly with no obvious way to return to pre-war conditions in the Strait of Hormuz or in the broader Middle East, also pushes up expected US military spending and the federal deficit.
The best theory of rates matters for the outlook on the US yield curve. If it is the price of oil and inflation, then eventually US-Iran and the price of oil should find a steady state and inflation should decline. Rates presumably would decline, too. But if it is demand for money, then the tech buildout looks likely to run for at least several years. While that demand for money remains in the market, US yields should remain in the range they have trace since the end of April.
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The view in rates
The market for now is pricing 45 bp of Fed tightening by the end of 2026 with very little through 2027. That should put a floor on the front of the curve at 4.00% or higher through 2026 depending on US-Iran and expected short-term inflation. If US-Iran accelerates, the likely Fed path could go higher and take short rates with it. The 10-year note meanwhile continues to look like it will spend more time above 4.40% than below it for the balance of the year. A lasting and stable agreement between the US and Iran could take 10-year yields reliably below 4.40%. How that agreement might come about seems far from obvious.
Key market levels:
- Setting on 3-month term SOFR traded Friday at 381 bp, up 8 bp on the week
- Further out the curve, the 2-year note traded Friday at 4.33, up 15 bp on the week. The 10-year note traded at 4.68%, up 13 bp.
- The Treasury yield curve traded Friday with 2s10s at 34 bp, flatter by 3 bp in the last week, and with 5s30s at 73 bp, flatter by 6 bp
- Breakeven 10-year inflation traded Friday at 224 bp, down 1 bp on the week, with 5-year forward 5-year breakeven at 228 bp, up 8 bp in the last week. The 10-year real rate finished the week at 243 bp, up 13 bp on the week.
The view in spreads
The supply and demand balance looks neutral-to-negative for MBS, neutral for corporate debt in general but particularly weak for technology. MBS net supply continues to run very low, but the expected steady bid from Fannie Mae and Freddie Mac has not materialized. Insurers continue to issue annuities and buy corporate and structured credit, but credit is facing significant needs to finance capital investment. In risk assets, carry is likely to dominate returns. Stay overweight in MBS and up-in-coupon to add carry and shorten spread duration. Stay overweight corporate credit generally but underweight in tech.
The Bloomberg US investment grade corporate bond index OAS traded on Friday at 78 bp, wider by 2 bp on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 116 bp, out by 6 bp on the week. Par 30-year MBS TOAS closed Friday at 27 bp, wider by 4 bp on the week.
The view in credit
Big companies have healthier balance sheets than smaller companies. Consumers at the middle-to-higher end of the income distribution also have low debt burdens, liquidity and wealth. Bank lending to non-bank financial institutions, including private debt funds and business development companies continues to expand. Bank regulators continue to focus on that category of lending, which could eventually tighten the private credit markets. But for now, credit metrics for NBFI lending are strong relative to traditional bank lending such as C&I.
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