The "anchor for global asset pricing" is no longer dormant. With Jerome Powell's term concluded, Kevin Warsh, personally nominated by former President Donald Trump, officially assumed leadership of the Federal Reserve this week. However, bond investors are betting that he will prioritize maintaining the Fed's inflation-fighting credibility over responding to political pressure for lower interest rates. This expectation is fueled by a more robust U.S. growth trajectory, driven by geopolitical tensions in the Middle East, a domestic frenzy in AI computing infrastructure investment, and surging portfolio returns for high-net-worth individuals.

Furthermore, veteran Wall Street bond strategists suggest that even if a temporary peace agreement is reached in the Middle East and the Strait of Hormuz reopens, market expectations for tighter policy and the recent surge in yields—particularly the benchmark 10-year U.S. Treasury yield, often dubbed the "anchor for global asset pricing"—may not quickly recede. The current rise in long-term yields is not solely attributable to inflation expectations but stems more significantly from an increase in real yields, growing concerns over the sustainability of the massive U.S. debt burden, and heightened capital market financing demands spurred by the AI investment boom.

These underlying trends imply that rising interest rates in the denominator of Discounted Cash Flow (DCF) models could exert sustained "repricing pressure" on highly-valued tech stocks closely linked to AI computing power. As the risk-free rate anchor in DCF models, if the 10-year Treasury yield remains persistently elevated, the AI-driven bull market may not necessarily end but could transition from a "valuation expansion bull market" to an "earnings validation bull market."

Amid the largest inflation surge since 2023, triggered by conflict in the Middle East, global bond traders are actively pricing in the near-certainty that the Fed will begin raising interest rates before December. Market pricing now reflects a 100% probability of a 25 basis point hike by year-end, a dramatic reversal from just three months ago when expectations leaned toward deeper rate cuts under Warsh's leadership. This shift reflects the impact of geopolitical turmoil, resilient U.S. economic growth, and the AI investment wave fueling equity markets—all factors intensifying concerns that inflation may linger above the Fed's 2% target for some time.

In a volatile trading week, the yield on the two-year U.S. Treasury note—most sensitive to Fed policy expectations—briefly climbed to 4.14% last Friday, its highest level in over a year, trading nearly 40 basis points above the upper bound of the Fed's benchmark rate. The 30-year yield briefly touched 5.2%, a level not seen since 2007, before settling around 5.06%. The benchmark 10-year yield surged toward 4.7%, a high since January 2025, before retreating to approximately 4.5%.

As the chart illustrates, the two-year yield has broken above the key Fed policy rate benchmark. Warsh formally takes the helm as an increasing number of Fed officials abandon their dovish policy bias. Fed Governor Christopher Waller, a Trump appointee with a permanent FOMC vote who earlier this year advocated for rate cuts to protect the labor market, stated last Friday that the likelihood of the Fed's next move being a hike is now on par with that of a cut. Several other key policymakers, including Vice Chair Philip Jefferson and New York Fed President John Williams, are scheduled to deliver important speeches this week, with their recent remarks also generally shifting toward a more hawkish, rate-hike-inclined stance.

Notably, during Warsh's swearing-in ceremony on Friday, Trump—who had repeatedly pressured the Fed to lower borrowing costs—did not continue advocating for rate cuts as some expected. Instead, he emphasized his desire for Warsh to lead the central bank independently.

Is the market overpricing rate hikes this year? Some capital sees opportunity in short-term Treasuries.

With yields having risen sharply and the market appearing to overprice Fed hike expectations, some seasoned bond investors, including Capital Group portfolio manager Chitrang Purani, are adopting a more bullish stance on short-term U.S. Treasuries. Purani stated, "I do believe the bar for hiking remains quite high, as this FOMC committee and the Chair may wish to be more patient with policy before taking the next key step, to fully understand how inflation transmits to the labor market and financial market conditions." He added, "Personally, I don't believe the Fed's reaction function to economic data under Warsh will be substantively different from the past."

The Japanese government bond (JGB) market serves as a notable case: stronger-than-expected domestic inflation and growth, the potential for further Bank of Japan rate hikes, fiscal concerns exacerbated by supplementary budgets, and life insurers reducing allocations to ultra-long JGBs have collectively steepened the JGB yield curve. However, global fixed-income giant Pacific Investment Management Co. (Pimco) believes "pessimistic pricing" has gone too far, with 30-year bonds offering excessive compensation relative to 10-year bonds, leading them to favor holding ultra-long 30-year JGBs.

In stark contrast to bond market pricing, which at one point factored in a Fed rate hike this year, economists overall maintain a more moderate outlook. They continue to view the inflation spike driven by energy prices since the Middle East conflict began two and a half months ago as transitory and unlikely to spread more broadly to other consumer prices. In a survey of 101 economists conducted from May 14-19, nearly 85% (83 respondents) expect the benchmark rate to remain unchanged within the 3.50%-3.75% range through the third quarter. This compares to just over half last month and nearly 70% in March who anticipated at least one cut by then. Regarding year-end levels, while no clear consensus exists, nearly half (49 of 101) expect no change in rates this year, up from about one-third previously. Nearly one-third anticipate one cut this year, mostly in December. Only four economists forecast a hike before December.

Beyond parsing Fed officials' remarks, bond traders this week will also focus on auctions of two-year, five-year, and seven-year U.S. Treasuries for signs of demand from global institutional investors.

War may cease, but yields may not fall! With the Warsh era beginning, the U.S. bond market appears to be entering an era of "higher long-term yields."

Over the weekend, media reports suggested the U.S. and Iran are close to an agreement extending the existing ceasefire by 60 days, during which the Strait of Hormuz would reopen, and Iran would be permitted to sell its oil. However, due to ongoing negotiations over precise wording on key issues, no document will be signed immediately, and final approval may take several days.

"Bond vigilantes" are effectively sending a counter-signal to calls for lower rates: if new Fed Chair Warsh prioritizes the central bank's inflation-fighting credibility, short-term yields will find support from hike expectations; while record U.S. fiscal deficits, AI data center debt financing, and a higher neutral rate will continue to weigh on long-term Treasury prices. This suggests the long-end of the bond market faces not a single geopolitical shock but a deeper global re-evaluation of the savings-investment balance: the war may eventually stop, but the environment of higher long-term yields may not cease with it.

Despite rampant anxiety over war-related inflation fears, signs indicate other drivers are exerting equally significant influence on longer-term borrowing costs. In the U.S., the so-called real yield curve—yields adjusted for inflation—is having a greater impact, suggesting bond investors are worried about more than just price pressures from the Middle East conflict. Other culprits include: signals that the already massive public debt burden will swell further; the effects of the AI investment boom; and the rising possibility of central banks, including the Fed, hiking rather than cutting rates.

Jonathan Hill, head of U.S. inflation strategy at Barclays, stated, "The narrative that global duration assets are being sold off due to inflation expectations is hard to square with market pricing for medium-to-long-term inflation risks." He added, "Instead, the interplay of rising debt levels, a potentially higher neutral rate, and the massive financing needs from the scale of AI investment may be driving real yields persistently higher."

The neutral rate is the level that neither stimulates nor restrains the economy. While surging oil prices may grab headlines, breakeven inflation rates—a market gauge of inflation expectations—have not risen as much as overall yields in the U.S. and U.K. Hill points out that even with the ongoing conflict, the U.S. 10-year breakeven rate remains a full 50 basis points lower than in the first half of 2022, when the Fed was aggressively hiking. The so-called 5-year, 5-year forward breakeven inflation rate—a key proxy for medium-term inflation expectations—stands around 2.2%, roughly its level from last December.

As shown in the chart, the drivers of high yields vary across major global bond markets. In Japan and Germany, rising breakeven inflation rates since the conflict began explain most of the increase in 10-year yields. Europe faces higher natural gas prices, while Japan's inflation pressures were already rising before the conflict. Analysis now suggests the Bank of Japan's reluctance to hike is forcing JGB market investors to demand more compensation for inflation risk.

Subtracting inflation-adjusted yields from nominal rates leaves real yields; some market participants view real yields as a truer measure of borrowing costs. Analysis from Bloomberg shows that in the U.S., rising real yields explain the majority of the overall yield increase, whereas in Japan and Germany, inflation is the primary factor.

Padhraic Garvey, Regional Head of Research, Americas at ING, stated that such dynamics imply that even if the Strait of Hormuz—a key global energy chokepoint closed due to conflict—ultimately reopens, long-term rates "could get a bit stuck at higher levels" as long as real yields remain elevated. He believes "almost all" of the rise in the U.S. 10-year yield above 4.5% is attributable to higher real yields. The benchmark U.S. 10-year yield approached 4.70% on Tuesday before retreating to 4.56% on Friday.

As the chart maps, the surge in U.S. Treasury yields is almost entirely driven by real yields. Garvey added, "A reopening of the Strait of Hormuz would dampen inflation expectations but could leave real yields elevated; if so, then Treasury yields wouldn't fall as much as many currently expect."

Mark Malek, Chief Investment Officer at Muriel Siebert & Co., wrote in a client note, "The bond market isn't responding to one headline." He continued, "It is repricing a structural issue that cannot be solved by a press release or a short-term ceasefire agreement."

In early Asian trading Monday, crude oil prices fell, and U.S. Treasury futures edged higher. The global crude benchmark Brent fell as much as 5.2% to $98.12 a barrel, while WTI crude approached $92.

In an era of higher long-term Treasury yields, heightened volatility in global risk assets like tech stocks may become the norm.

JPMorgan Chase CEO Jamie Dimon, often called "Wall Street's top banker," stated in a media interview last week that U.S. rates could rise significantly further, citing concerns over government borrowing and debt demand. Phillip Lee, head of real money rates sales at Goldman Sachs, argues that persistent fiscal deficits, increased U.S. Treasury supply, and debt sustainability concerns are increasingly explaining why investors demand extra compensation for holding longer-dated bonds—the so-called higher "term premium." He stated on a Goldman Sachs podcast, "I think the yield curve goes higher."

Rising real yields, expanding fiscal deficits, AI capital expenditure absorbing savings, increased long-term Treasury supply, and a potential greater emphasis on inflation-fighting credibility under Warsh's Fed. In other words, while geopolitical tensions may ease, the underlying constraints for higher rates may not disappear with them. Strategists and traders widely believe the recent jump in long-end Treasury yields will not fully reverse even if oil-driven inflation subsides, with rising real yields explaining most of the increase in U.S. yields.

The fiscal situation is the first source of stickiness preventing long-term yields from declining. The U.S. is already in a state of high debt and high interest expenses. If combined with potential tariff rebates, tax cut demands, military spending expansion, and rising debt servicing costs, fiscal deficit pressures could widen anew. This implies the Treasury Department will need to issue more bonds continuously, and long-term investors will demand a higher term premium to absorb the supply.

The unprecedented AI investment boom is becoming a new variable for long-term Treasury yields. While it may lower unit costs through productivity gains in the long run, in the short to medium term, it pushes up capital demand: tech giants are issuing corporate debt in concentration, data center construction requires capital expenditure for power, land, equipment, semiconductors, and grid upgrades, and interest rate swaps and project financing create "synthetic duration" supply. More importantly, the AI frenzy makes equity assets relatively more attractive, leading asset allocators to demand higher yields from bonds as compensation. Therefore, AI is not simply a "disinflationary technology"; during its build-out phase, it acts more like a capital expenditure black hole absorbing global savings and pushing up the equilibrium real interest rate.

Global resonance in long-term bonds will also limit the room for U.S. Treasury yields to fall back, especially as long-dated government bonds worldwide are demanding higher risk compensation based on term premiums. If the Japanese government continues to face inflation pressures and rising ultra-long JGB yields, enhancing the attractiveness of domestic assets, it could weaken marginal overseas demand for U.S. Treasuries. If fiscal and political uncertainty rises in the U.K., gilt risk premiums could spill over to global duration assets.

The long-term U.S. Treasury market is undergoing a large-scale shift from "temporary inflation shocks driven by geopolitical conflict" to "structural high-yield curve pricing driven by fiscal policy, AI, rising real yields, and a shifting neutral rate." A peace agreement may ease risk premiums and oil price shocks but will not automatically resolve deficit expansion, Treasury supply, AI financing competition, and the reversal of the global savings-investment balance.

If the 10-year U.S. Treasury yield—a crucial risk-free rate anchor in the denominator of DCF valuation models—remains persistently elevated, valuation volatility for risk assets like stocks will be more easily amplified. The 10-year yield is commonly used to discount future earnings and cash flows; when it rises, the cost of capital increases, and the present value of future cash flows declines, particularly pressuring high-valuation tech/growth stocks, small caps, real estate, consumer discretionary, and highly leveraged assets.

More precisely, this is not simply a case of "high yields = stocks must fall." It signifies that risk assets are entering a pricing environment characterized by higher volatility and greater differentiation. In other words, a "valuation expansion bull market" may give way to an "earnings validation bull market," with heightened volatility and sector dispersion likely becoming the norm. If corporate earnings are sufficiently strong—for instance, if AI leaders continue to deliver profits—stock prices could still rise. However, valuation error margins will shrink; any disturbance in earnings expectations, AI capital expenditure returns, oil prices, or fiscal deficits could trigger rapid repricing by the market through higher discount rates and risk premiums.

Morgan Stanley strategists recently noted that with long-term Treasury yields entering a "danger zone," the overall U.S. stock market still relies on AI and strong earnings for support. However, if market breadth remains narrow, high-volatility/high-momentum/high-valuation tech stocks will be more sensitive to bond sell-offs. The risk assets truly capable of navigating a high-yield environment must simultaneously possess high free cash flow, pricing power, low leverage, genuine earnings growth, and a sufficiently robust AI revenue generation/productivity realization thesis.