Inflation expectations cool but real yields climb: Why are global capital costs remaining high?

The New Bet in Bond Markets: Higher for Longer

Recently, a seemingly contradictory signal has emerged in the global bond market: although inflation expectations have decreased due to the easing of the Iran situation and falling oil prices, overall borrowing costs have not followed suit. Instead, real yields have surged significantly, offsetting the contraction of the inflation premium and keeping benchmark interest rates elevated. This phenomenon has profound implications for institutional investors' asset allocation strategies.

Market Background

In early July 2026, the situation in the Iran war eased, and expectations of restored oil supply led to a decline in energy prices. According to Axios, the U.S. five-year breakeven inflation rate (i.e., the market-implied inflation expectation) plummeted from a May peak of 2.7% to 2.3%, and the ten-year breakeven rate also fell back to around 2.2%. Federal Reserve Chairman Kevin Warsh explicitly stated that "inflation risks have declined," further reinforcing market confidence in controlled inflation.

However, at the same time, real yields (i.e., nominal interest rates minus inflation expectations) have moved counter to this trend. Since the beginning of May, the five-year real yield has jumped from 1.3% to 1.9%, and the ten-year real yield has risen from 1.9% to 2.2%, both approaching their highest levels of the year. This means that despite the shrinking inflation premium, the real returns demanded by investors have increased substantially, keeping overall interest rates (such as the ten-year Treasury yield) at a high level of around 4.5%.

Current Capital Flows

This dynamic in the bond market has directly affected the pricing of risk assets and capital flows. Interest-rate-sensitive sectors, such as real estate and auto loans, have not found relief from easing inflation. For example, U.S. mortgage rates have recently remained around 6.6%, far higher than the 6% level just before the Iran conflict erupted in late February.

From a capital flow perspective, strong global demand for capital is a key factor driving up real yields. Aditya Bhave, Chief U.S. Economist at Bank of America, noted that massive investments in artificial intelligence (AI) infrastructure are consuming enormous amounts of capital. On July 7, Amazon announced the issuance of $25 billion in bonds, with proceeds used for AI infrastructure construction. At the same time, governments around the world face huge fiscal deficits and may borrow further for national defense buildup. This capital demand, combined with the Federal Reserve's policy of maintaining high interest rates, creates a synergistic effect.

Investment Logic Analysis

Why have real yields risen when inflation expectations are falling? Multiple structural drivers lie behind this phenomenon.

First, the AI investment wave is reshaping capital demand. Companies are investing heavily in data centers, computing power, and technological infrastructure. Amazon's $25 billion bond issuance is just the tip of the iceberg. This long-term investment demand supports interest rate levels.

Second, fiscal deficit expansion. Major global economies, especially the United States, are still implementing large-scale fiscal stimulus, with government debt issuance remaining high. Even if inflation pressures ease, the supply pressure from government bonds may keep interest rates elevated.Third, Central Bank Credibility and Economic Growth Expectations. Under Warsh's leadership, the Fed has shown stronger determination to fight inflation, making market pricing of inflation expectations more credible. Meanwhile, falling energy prices have removed a major drag on consumer spending, easing concerns about an economic recession. Bhave noted that two months ago, the market was worried about "how long consumers can hold up," but that concern has now faded. Improved economic growth expectations imply higher expected returns on capital, thereby pushing up real interest rates.

Fourth, Productivity Improvement Expectations. If the economy achieves stronger productivity and corporate efficiency improvements under a more relaxed regulatory environment, the long-term growth potential expands, further sustaining strong capital demand and keeping real interest rates high.

Risk Factors

Institutional investors should pay attention to the following risks:

• Macro Risk: Persistently high real yields may suppress investment and consumption, ultimately dragging on economic growth. If the economic slowdown exceeds expectations, it could lead to a rapid decline in interest rates.
• Policy Risk: If the Fed tightens again due to inflation recurrence, interest rate volatility will increase. Additionally, a lack of fiscal discipline could trigger sovereign credit concerns.
• Geopolitical Risk: Although the situation in Iran has temporarily eased, uncertainties remain in the Middle East. Any new conflict could drive energy prices to surge, reversing the improving trend in inflation expectations.
• Market Valuation Risk: Current real yields are at high levels, putting pressure on assets that rely on discount rates (such as growth stocks, long-term bonds). A high interest rate environment may trigger asset price repricing.

Long-Term Outlook

From a 3-10 year perspective, the world is in a structural cycle of rising interest rates. Investments in AI and the digital economy, green energy transition, rising defense spending, and fiscal pressures from population aging will all continue to support capital demand. Institutional investors should consider increasing allocations to real assets, infrastructure, and private credit, which can hedge against high interest rates. At the same time, bond investments should focus more on real yields rather than nominal yields, using inflation-protected securities (TIPS) to manage risk.

Overall, while improved inflation expectations bring short-term benefits, the rise in real interest rates reveals a deeper imbalance between capital supply and demand. Investors need to move beyond the traditional interest rate cycle framework and embrace a new normal of "higher for longer" interest rates.

*This article is based on an Axios report (Courtenay Brown, Neil Irwin, July 7, 2026) and other public information.*