The decomposition of bond yields rests on two factors: first, expectations, or the average of future short-term interest rates; and second, a term premium that reflects compensation demanded by investors to hold riskier long-term bonds. Given that expectations are anchored by Federal Reserve policy guidance, approximately 80% of the recent increase in yields on the U.S. 10-year Treasury can be attributed to the term premium, with only 20% credited to changing expectations of where short-term rates will be over the next 10 years.
While the term risk premium remains low relative to historical norms, this strongly suggests that investors are pricing in a regime change in interest rates toward higher levels than have been the norm over the past two decades.
Moreover, given the arrival of expansionary fiscal policy with the incoming presidential administration, this also suggests that investors are pricing in higher government spending, annual operating deficits, greater volatility and a rising premium to hold U.S. debt.
These factors strongly imply that the equilibrium level on the U.S. 10-year should be in a range of 4.5% to 4.75%. We expect the U.S. 10-year to trade between 4.3% and 4.7% in 2025, with an average of 4.5% during the year.
One risk around an otherwise solid 2025 economic outlook is if the 10-year rate were to test 5%; that would reignite risk around local and regional banks that hold roughly 70% of commercial real estate notes, as they would find it challenging to refinance that debt at such levels. The last time the market tested such levels was during 2023’s March-to-April mini banking crisis, which required the Fed to create the Bank Term Funding Facility to ring fence troubled lenders and prevent a run on banks.
