Defying Rising Bond Yields: Consumers Continue to Spend and the Economy Continues to Thrive

Rising bond yields, tariffs and soaring energy prices have not been enough to slow the economy.

This week, the yield on the 10-year Treasury note — which influences mortgage rates and other borrowing costs — rose to 5.2%, marking its highest level in nearly 20 years.

As analysts and economists have pointed to a cocktail of stubborn inflation fueled by rising oil prices, demand for AI company bonds and a record $40 trillion in federal debt, a debate has emerged over how much of the rise in yields is due to a strengthening economy — and how much the economy can sustain.

“The main reason bond yields have risen sharply is that the U.S. economy is booming,” said Ed Yardeni, chief investment strategist at Yardeni Research.

This week, a report that usually gets little attention, the S&P Purchasing Managers’ Index, showed that the economy could be regaining strength. The report, which measures manufacturing activity, recorded its biggest monthly increase since 2022, while figures for the services sector rose to their highest level since 2021, thanks to new orders.

The labor market is showing similar resilience. August payrolls jumped by 162,000, while the unemployment rate remained stable at 4.1%. Until this spring, health care and social assistance had largely driven the job market. Since then, hiring has expanded to include a wider range of industries, and over the summer, total job openings averaged 74,000 per month.

Top policymakers at the Federal Reserve see consumer strength as the main driver. Federal Reserve Chairman Kevin Warsh emphasized at a recent press conference that economic strength is the primary driver of long-term returns.

At a panel Friday, Cleveland Federal Reserve President Beth Hammack said a number of factors were driving yields higher, pointing to a strong economy as a key factor.

Learn more: How the Fed’s Rate Decision Affects Your Bank Accounts, Loans, Credit Cards, and Investments

“I think the growth numbers have been pretty solid,” she said at the Cleveland panel. “I think the expectations for continued performance, if you look at the earnings and profits of various public companies, have been better than expected, and there have been signs of resilience that markets are starting to price in, I think.”

She acknowledged that markets are pricing in more interest rate hikes and that the United States is on an unsustainable fiscal path.

Philadelphia Federal Reserve President Anna Paulson also said this week that she sees a resilient economy that is showing signs of accelerating despite tariffs and rising oil prices. She noted that consumer spending has been strong, the development of AI is driving investment and the job market is stable.

After a slow start to the year, growth in real consumer spending accelerated to an annualized rate of 3.4% in the second quarter, and the Atlanta Fed’s GDPNow model currently projects consumer spending to exceed 4% in the third quarter. Paulson believes the growth momentum in consumer spending will likely be driven by the surging stock market.

Hammack noted that economic growth has held up reasonably well and the job market is hovering around his estimate of maximum employment.

“We’ve been expecting the consumer to pull back for several years, and that’s really not the case,” she said. “They continued to spend, and that fuels the economy.”

Not everyone agrees that growth is the main driver of rising yields. Wil Stith, senior bond portfolio manager at Wilmington Trust, said he thought growth partly explained the rise in bond yields, but that “the big thing” was high government spending and budget deficits.

“We and our allies are on a war footing…The trajectory of fiscal spending is increasing, and no one is really asking if we’re going to fix this, how long is this going to last?” Stith said in an interview. “This is the main reason we are currently seeing rising long-term yields.”

Stith noted, however, that if the economy contracts, bond yields would be lower.

Where do returns go from here?

Stith thinks the yield on the 10-year Treasury note, currently around 5.2%, could peak at 5.5%. If the yield starts to rise above that level, the Fed would likely raise rates further, leading to more pain for the economy and a sell-off in stocks, which has helped boost consumer spending.

Learn more: How Surging Treasury Yields Could Affect Your Finances

So far, Yardeni said the yield on the 10-year Treasury note remains below the nominal GDP growth rate, which was 6.6% in the second quarter and will likely be even higher in the third quarter. In the past, notably in the 1980s, so-called “bond vigilantes” have pushed bond yields above nominal GDP to slow the economy.

“They haven’t done it until now,” he said. “The risk is that they will if the Fed fails to bring inflation under control.”

Yardeni said he expects the 10-year bond yield to stabilize in the 4.00% to 5.00% range this year, mirroring the range in the five years before the 2008 financial crisis. “Nevertheless, the risks now clearly point to a further rise in yields,” he said.

For yields to fall, it will likely require a resolution to the Middle East war that would lower oil prices. Another possibility, Yardeni said, is that Treasury Secretary Scott Bessent acts to lower bond yields by buying back more Treasuries and issuing more Treasuries.

The Fed’s next actions

Faced with growth and persistent inflation due to global conflicts involving Iran, Russia and Ukraine, the Federal Reserve abandoned its earlier hopes of lowering rates. After a rate hike in September, Wall Street is now preparing for further rate hikes.

Markets are now pricing in a 66% chance that the Fed will make further rate hikes in October and a 52% chance that it will do so again in December.

Hammack suggested the Fed should raise rates further.

“We are currently in an environment in which I do not see our political position as a barrier to investment in the economy,” she said.

She emphasized that when she talks to businesses about new investments, interest rates are not a factor for most, outside of the housing sector.

“So they continue to invest in the economy, which is a good thing. We like that from a growth perspective,” she said. “But if that creates more inflationary pressures, that’s something we need to be aware of and make sure we bring that back under control.”

Stith said that if economic data continues to be good, both in terms of growth and employment, and if inflation is higher than expected, the Fed will raise rates again in October and December. He doesn’t think a quarter-point increase is enough to bring down inflation, and another quarter-point probably won’t be enough either. He thinks the Fed is looking at a 100 basis point rate hike instead.

And yet, if borrowing costs continue to rise, it may not slow the economy like it has in the past.

Bill Ackman, CEO of Pershing Square, posted on »

“What if the old models don’t apply to the current paradigm and the Fed is wrong?” he continued.

Against this backdrop, he said he thinks the Fed might have made a mistake in raising rates.

Jennifer Schonberger is a veteran financial journalist who covers markets, economics and investing. At Yahoo Finance, she covers the Federal Reserve, Congress, the White House, Treasury, the SEC, the economy, cryptocurrencies, and the intersection of Washington politics and finance. Follow her on @Jenniferismes and on Instagram.

Click here for the latest economic news and indicators that will help inform your investment decisions.

Read the latest financial and business news from Yahoo Finance