AI Investment and Government Borrowing Push Up Neutral Rate, Amplifying Bond Selloff
nashnova research
Investors are betting the neutral interest rate (R-star) is rising; the New York Fed's latest model puts it at 1.65%. If correct, rates stay structurally high for years — and the bond sell-off is far from over.
What is the neutral rate, and why does it matter now?
R-star is a theoretical level: the interest rate at which the economy neither overheats nor stalls. This means → it is the invisible anchor for every Fed rate decision. Raise the anchor, and all rates follow it up.
The New York Fed's latest Laubacher-Williams model estimates R-star at 1.65% for Q2 2026, up markedly from 1.36% a year earlier.
Market participants widely believe the model underestimates the true figure. Massive bond issuance tied to AI infrastructure, plus ballooning government borrowing, are both pushing the real neutral rate higher. In plain terms = the model says 1.65%; the market thinks it is higher — no one can pin down exactly how much.
What is driving the neutral rate higher?
Chip Hughey, managing director of fixed income at Truist Wealth, points to two key forces: large-scale AI investment and rising government debt levels. Both compete for capital → capital gets more expensive → real yields climb.
Amazon, Microsoft, and Google are issuing long-dated bonds in size, competing directly with U.S. Treasuries for investor money. This means → Treasuries are no longer the only "big borrower" at the long end — the competition alone pushes rates up.
U.S. national debt has crossed $40 trillion. Sustained government borrowing is a separate upward force, independent of AI.
How is the yield curve reacting — and why is the 30-year hit hardest?
Zachary Griffiths, head of IG and macro strategy at CreditSights, says a higher R-star is "pushing the entire yield curve up."
At the short end, 2-year and 5-year yields rise because a higher R-star means the Fed ultimately holds policy rates at a higher floor. At the long end, 10-year yields face a double hit: higher policy-rate expectations plus a widening term premium — the extra compensation investors demand for locking up money longer.
Griffiths notes the impact on 30-year yields is "historically asymmetric" — the ultra-long end bears the most pressure. This reflects how high debt levels and persistent fiscal deficits compound investors' demand for compensation at the longest maturities.
Can rates ever come back down?
UBS CIO Americas head Ulrike Hoffmann-Burchardi is blunt: with capital demand structurally this high, the Fed "cannot easily bring rates back to zero."
But there is a counter-argument. Griffiths contends the AI-driven R-star rise may be temporary — in the near term, AI construction absorbs capital and lifts rates; over the longer horizon, if AI produces deflationary or even deflationary effects, nominal policy rates could actually fall.
In plain terms = AI is in its "spending phase" now, pushing rates up. If AI eventually makes goods cheaper, rates may reverse. Whether R-star is experiencing a cyclical bump or a structural repricing is the single most important variable for judging how long this bond sell-off lasts.
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