Real rates drive selloff, rate-hike expectations explain most of the increase

According to the report, the 10-year U.S. Treasury yield has risen more than 100 basis points since the start of the year, up about 130 basis points from its year-to-date low on the eve of the U.S.-Iran conflict.

But the forces driving yields higher have shifted across different phases. Since late February, the front end of the curve and nearer-term forward rates have explained a larger share of the move; the most recent selloff has been driven more by longer-term forward rates.

Looking at the composition of yields, despite persistent market discussion of inflation risks, breakeven inflation rates have contributed little to this repricing, with the rise in longer-term yields coming mainly from real rates.

Both judgments can hold simultaneously: inflation compensation has barely changed, yet the market has raised its expectations for future policy rates because of inflation risks. The energy shock has investors worried that the Fed needs to maintain tighter policy, while economic performance has weakened the case for rate cuts.

Goldman Sachs' model decomposition shows that consensus forecasts for short-term rates over the next year have risen about 125 basis points since the start of the year, contributing roughly 55 basis points to estimated long-term forward rates, or about 70% of their cumulative increase.

The long-term forward rate here mainly refers to the 5y5y, a forward rate starting in five years with a five-year term, not the current 10-year Treasury yield.

This round of policy expectation revisions began with the energy shock and was subsequently supported by labor market stability and economic resilience. The report notes that February was the peak of market concerns about AI disrupting employment; as those concerns eased, investors began to accept a higher future rate path.

Applying the same analysis to 10-year Treasury yields, Goldman Sachs estimates that policy path adjustments contributed about 80–85 basis points. Other factors contributed less, leaving roughly 10–15 basis points unexplained by its fundamental framework.

Evidence that AI is pushing rates higher shows up more in growth expectations

AI infrastructure investment continues to rise, and capital expenditure and borrowing expectations among hyperscale tech companies keep moving higher. This has made "corporate and government financing competing for funds" a popular narrative to explain high rates.

Goldman Sachs acknowledges AI investment's impact on rates but distinguishes the transmission mechanisms.

First, AI spending can support current economic activity and raise the market's assessment of cyclical resilience. If growth remains strong, the Fed has less room to ease policy.

Second, AI investment may raise market expectations for long-term growth, thereby lifting the fair level of long-term rates.

Therefore, AI investment can influence yields both directly through long-term growth expectations and indirectly through policy rate expectations.

By contrast, the report is more cautious about the explanation that "corporate debt issuance continues to push Treasury yields higher."

Goldman Sachs found that large-scale investment-grade bond issuance can indeed have a localized impact on long-term yields on the pricing date; but when the observation window is extended, this effect weakens significantly. Its research is not yet sufficient to support a stronger judgment: that the market absorbing corporate bond supply has become an important cumulative pressure driving Treasury yields ever higher.

The report also notes that the overall measure of U.S. long-term debt stock relative to GDP remained stable during the year, and privately held Treasuries as a share of GDP were also roughly stable. Long-term issues remain with the fiscal path, but these indicators have not shown a major turning point sufficient to explain this round of changes.

This does not rule out the impact of financing supply, but it limits the force of this explanation. Under Goldman Sachs' framework, changes in growth and policy expectations brought about by AI spending explain the current rate trajectory better than simply the scale of debt issuance.

Bonds' hedging value has declined, and investors are demanding more compensation

Fundamentals explain most of the rise, but not all of the market pricing.

At the time of the report, the 5y5y U.S. Treasury forward rate was about 5.5%–5.6%, roughly 40–50 basis points above the fair level estimated by Goldman Sachs' G10 model. This means that relative to the macro factors incorporated in the model, yields are too high and bond prices are too low.

This valuation gap is a different measure from the earlier statement that "about 10–15 basis points of the year-to-date increase cannot be explained": the former compares current rates with model fair value, while the latter decomposes year-to-date changes, and the two cannot be directly equated.

Goldman Sachs believes that higher macroeconomic uncertainty, along with the diminished hedging value of bonds, can explain part of the additional compensation.

Investors hold bonds typically also for their ability to provide protection when stocks fall. But an energy supply shock could simultaneously push up inflation risk, depress equity valuations, and drive bond prices lower. When stocks and bonds come under pressure at the same time, the portfolio diversification value of bonds declines.

When an asset becomes harder to rely on for protection, investors may demand a higher yield before they are willing to hold it.

At the front end of the curve, Goldman Sachs estimates that the market-implied policy path is about 40–50 basis points above survey forecasts. Higher rate volatility and changes in hedging value can explain about 25–30 basis points of that. Similar dynamics appear at longer maturities: rate volatility has risen, term premiums have increased, and energy prices continue to affect bond performance.

This shows that the rise in yields includes both a reassessment of the economy and policy and a change in the compensation investors demand for holding risk.

Fund deleveraging and passive hedging amplify selling pressure, but the amplifiers are weakening

Goldman Sachs' estimates of bond fund positioning show that funds continued to reduce duration exposure during the selloff and are now significantly underweight relative to the Bloomberg Aggregate Bond Index.

Duration measures how sensitive a bond's price is to changes in interest rates. Reducing duration means cutting the potential losses if yields continue to rise, while also reducing the price gains available if yields fall back.

Based on Goldman Sachs' historical observations, the current degree of underweight has reached levels that have often been followed by lower yields over the next three to six months. However, this is only a historical correlation and cannot by itself be taken as evidence that the market has already bottomed.

In addition, this selloff has been amplified by negative convexity hedging.

For mortgage-backed securities (MBS), rising yields typically reduce borrowers' willingness to prepay, extending the securities' expected life and duration. Investors who need to maintain stable interest-rate risk may then sell duration or pay fixed rates in the swaps market.

This creates a feedback loop: rising yields trigger more hedging; hedging trades in turn add further upward pressure on rates.

Goldman Sachs estimates that since early September, MBS holders may have generated about $60 billion in 10-year equivalent pay-fixed demand to maintain stable duration. But the report explicitly states that this estimate may be at the upper end of actual flows.

Over the same period, changes in the cheapest-to-deliver (CTD) bond for long-end Treasury futures also extended the duration of long positions. Goldman estimates that offsetting this change would require selling about $10 billion to $15 billion in 10-year equivalent duration. The two estimates may overlap and should not be simply added together.

The key point is that these technical factors may weaken going forward. The report notes that convexity at the MBS index level is already near zero, and CTD switch risk no longer clearly skews toward amplifying upward yield pressure.

Weaker technical selling pressure may not immediately bring a rebound, but it means further selling may lose some of its self-reinforcing force.

Goldman turns more bullish, but catalysts still await energy and growth shifts

Goldman's shift to a more bullish stance is mainly based on three points: longer-term yields are above model fair value, funds are significantly underweight duration, and some technical selling pressure has already weakened.

It also notes that credit spreads have begun to widen. This raises corporate financing costs, making the constraint of high rates on the real economy more evident, which in turn may create a feedback constraint on further rises in Treasury yields.

According to the report's estimates, if current yield levels persist, the drag on economic growth from financial conditions could expand from about 0.2 percentage points to more than 0.5 percentage points.

This means the economic resilience supporting high rates may also gradually be eroded by high rates themselves.

Goldman believes that a credible reduction in energy risk, weaker growth data, or diminished market confidence in the AI investment trade could all drive a relatively rapid decline in yields. If these catalysts do not appear, more data showing mild underlying inflation pressure would need to accumulate, a process that could take months.

The report maintains its forecast of 4.75% for the 10-year Treasury yield at year-end, but acknowledges that if energy risks persist and growth risks remain low, this forecast faces upside risk.

As a result, its strategic expression is relatively restrained. Goldman proposes receiving 10-year fixed rates in a butterfly trade composed of 5-year, 10-year, and 30-year SOFR rates, expressing the view that the 10-year rate will fall relative to both ends of the curve. This is a curve relative-value trade and cannot be directly equated with outright buying of long bonds.

Goldman Sachs' core judgment is that the conditions supporting a bullish stance on US Treasuries have improved. When yields actually decline still depends on whether energy risks, economic resilience, and inflation data begin to validate this judgment.

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