Are higher interest rates here to stay?

The sharp rise in interest rates over the past three months has many investors asking an important question: Is this simply a temporary spike tied to the conflict in the Middle East, or the beginning of a more durable move higher in long‑term rates? Concerns about inflation have been a major driver of the recent increase. But a closer look at the bond market suggests recent geopolitical tensions may only be amplifying an underlying trend that was already in place.

Oil prices are pressuring the Fed

The recent surge in oil prices has contributed to higher Treasury yields. Investors seem to understand that higher energy prices eventually feed through into broader inflation measures. That creates a difficult environment for the Federal Reserve, because elevated inflation reduces the Fed’s willingness to cut rates—and could even force policymakers to consider raising rates again if inflation pressures intensify.

The relationship between oil prices and the futures‑market‑implied federal funds rate for December 2026 has been striking. Since fighting in Iran intensified in late February, the two series have moved closely together. As oil prices climbed, markets steadily priced in a higher path for Fed policy rates.

Why lower oil prices might not fully reverse the move

At first glance, it might appear that a durable reopening of the Strait of Hormuz would solve this problem. But there are reasons to believe the story may not be that simple. First, oil prices may not fully return to prior levels even if shipping traffic normalizes. A geopolitical risk premium is likely to remain embedded in energy markets for some time, while shipping insurance costs, supply disruptions, and transportation bottlenecks may persist well after the Strait formally reopens. Historically, confidence and supply chains normalize much more slowly than headline events suggest.

The bigger story: Rising term premiums

More importantly, if we zoom out beyond the recent conflict, we can see that the broader rise in Treasury yields has not primarily been driven by Fed expectations. Instead, it has been driven by a steady increase in what is known as the term premium.

This becomes clear when comparing Treasury yields today versus two years ago. On May 27, 2024, the 10‑year U.S. Treasury yield stood at 4.47%. Two years later, the yield was exactly the same, but the underlying composition changed dramatically.

Two years ago, Treasury yields were driven almost entirely by expectations for future Fed policy. At that time, the average federal funds rate implied by futures markets over the next 10 years was approximately 4.52%. Today, that same figure has fallen considerably—to just 3.69%. Ordinarily, such a decline in Fed expectations would have pushed Treasury yields much lower. But that decline has been offset almost entirely by a sharp increase in the term premium.

What is the term premium?

The term premium is essentially the additional yield investors demand for locking money into longer‑term Treasury bonds instead of shorter‑term securities. That premium has risen for several reasons. Large federal budget deficits mean the Treasury Department must issue enormous quantities of long‑term bonds, increasing supply that markets must absorb. At the same time, the Federal Reserve is no longer acting as a major buyer of Treasury securities. In addition, investors have become increasingly concerned about future inflation, interest rate volatility, and broader political uncertainty. As those risks rise, investors demand greater compensation for owning long duration bonds.

Conclusion

The conflict in the Middle East has clearly accelerated the recent rise in interest rates through its impact on oil prices and inflation expectations. But the broader upward pressure on yields appears to reflect deeper structural forces—particularly the steady rise in the Treasury term premium.

This suggests that even if energy markets stabilize, long‑term interest rates may not fully return to the lower levels investors became accustomed to during the past decade. As a result, our Asset Allocation Committee continues to maintain an underweight position in long‑term U.S. Treasury bonds and a lower‑duration stance more broadly across fixed income.