On the eve of the 5% threshold, the U.S. Treasury sell-off presents a tough challenge for the market and the Federal Reserve

Zhitong Finance APP reports that the bond market sell-off has pushed a key U.S. Treasury yield close to the 5% mark, intensifying concerns from Wall Street to Washington about the impact of rising borrowing costs on the U.S. economy.

After oil price surges threatened a new wave of inflation shock and attempts by the Trump administration to ease pressure on the government debt market failed, the benchmark 10-year Treasury yield jumped to 4.97% at the end of last week. This is just a step away from its high in October 2023—when the yield briefly broke above 5% during a single trading session before retreating as buyers flooded in.

The recent sell-off has heightened the risks facing Federal Reserve Chair Walsh ahead of Wednesday's FOMC meeting, local time. Last Friday, the market only stabilized after data showed last month's consumer prices rose more than expected, reinforcing speculation that policymakers will begin to hike rates to curb inflation that has run above target for five years in a row.

“The Fed is clearly behind the curve,” said Tracy Chen, portfolio manager at Brandywine Global Asset Management. “In the medium term, yields will continue to rise.”

She said this is because some factors that are pushing long-term yields higher—such as the inflationary impact of the Iran conflict—are beyond policymakers’ control. “I'm not sure exactly how high it will go, but I do believe it will certainly break above 5%.”

Three Forces "Draining Liquidity" at Once

Global bond yields have been rising since President Trump waged war on Iran in late February, disrupting Middle East oil and gas supplies. In the U.S., the artificial intelligence (AI) boom—which is injecting massive amounts of debt into the market while also stimulating the economy—along with concerns over the ballooning federal deficit, have further contributed to the trend.

The rising yields have become a headache for Trump, as they ripple across the markets, sending the cost of mortgages and other loans higher ahead of the November mid-term elections.

Earlier this month, he threatened to cut all U.S. trade with certain countries if the Fed didn’t cut rates—a move that would almost certainly worsen the bond sell-off by amplifying inflation fears. Treasury Secretary Bassent tried to curb rising bond yields by increasing Treasury debt buybacks, but after his first such operation received a lukewarm response from investors, yields instead surged last week.

With little prospect of a resolution to the Middle East conflict in sight, investors are bracing for continued risks of bond market sell-offs. Ian Lyngen, head of U.S. rate strategy at BMO Capital Markets, said he expects the 10-year Treasury yield to “break above 5% in the very near term.”

What Exactly Does 5% Mean?

Breaking this level is not inherently significant—it hasn’t closed above 5% since 2007. However, such round number thresholds are often seen as key turning points that can catalyze decisions by investors and policymakers.

U.S. Treasury yields are especially important because they are the benchmark for other loans. In the stock market, they are also used as the discount rate to measure the present value of expected profits over future years. The higher the yield, the smaller the present value of far-off earnings.

Some investors say this could start weighing on equities—despite strong profits created by the AI boom and the resilience of the economy, stocks remain near record highs. In addition, high bond yields may prompt money to flow out of equities, as higher returns entice investors into bonds.

“If you see bond yields rise to 5% or 5.25%, I think that’s when you will see some digestion and adjustment in the stock market,” said Grace Peters, global head of investment strategy at J.P. Morgan Private Bank. “The 5% threshold carries a strong psychological effect.”

A previous survey of 122 market participants showed about 30% believed a 10-year yield of 5% to 5.25% would be enough to prompt a 10% decline from peak in U.S. stocks—a technical correction; another 22% set the trigger at between 5.25% and 5.5%. Notably, more than two-thirds of those surveyed saw the real danger sign as the speed of the rise, not the absolute level of yields—disorderly and rapid sell-offs pose the biggest risks.

Macro strategist Brendan Fagan said, “Inflation remains significantly above target, while the federal government needs to finance massive deficits in an already heavy supply environment. If nominal economic activity stays near current levels, and the Fed has implicitly come to accept 3% inflation as 2%, long-term rates are bound to rise.”

Last week's turbulence—the two-year U.S. Treasury yield saw its biggest one-day jump since Trump’s tariff moves roiled markets in April 2025—ratcheted up pressure on the Fed.

This is because part of the sell-off in recent months has been driven by doubts about Walsh. At his first post-meeting press conference in June, he emphasized his focus on bringing inflation back to the Fed’s 2% target. But after rates were again left unchanged in July, traders sold off longer-dated Treasuries, doubting whether he would follow through on that promise.

Last Friday, after the U.S. Labor Department reported that a core inflation gauge rose more than expected, traders bet the Fed would likely be forced to act. Futures markets began pricing in about a 90% chance of a 25-basis point rate hike after the upcoming meeting.

“The more the Fed can demonstrate its anti-inflation credibility, the more likely it is to compress the risk premium at the long end of the Treasury curve in the medium term,” said Daleep Singh, chief global economist at PGIM Credit.

Even so, other factors driving yields higher are still in play. The federal deficit hit $2 trillion in the first 11 months of this fiscal year. Last week, Trump proposed that if Republicans retain control of Congress in the upcoming elections, he may send out $5,000 checks to every U.S. adult, with total spending exceeding $1 trillion—the White House economic advisers called it a “serious proposal.” The Middle East conflict is also escalating, pushing oil prices to a four-month high.

The J.P. Morgan strategist team led by Jay Barry said they expect a rate hike this week, but since traders may react to the Fed statement and Walsh's press conference, they remain “bearish” on longer-dated Treasuries. Others voiced caution, saying that if the Fed surprises investors, the sell-off could reignite.

“If the Fed doesn’t raise rates, the sell-off at the long end could become even more disorderly,” said Columbia Threadneedle portfolio manager Ed Al-Hussainy.