The future yields' form

In order to keep government debt costs low, central banks are likely to purchase short-term bonds

Share I warned investors to "beware the long bond" at the beginning of 2025. The best news is that during the year, yields on the bonds with the longest maturities did not soar. Both the 30-year gilt and the 30-year Treasury are coming to an end. Indeed, the 30-year Japanese Government Bond (JGB) increased from 2.3 percent to 3.4 percent, while the 30-year bund increased from 2.6 percent to 3.5 percent. This is good, though, because higher long-term rates are a step toward normalcy in a world where investors were willing to lend money for thirty years at extremely low rates (well under one percent at times in Japan).

At the same time, early signs of a significant change are emerging. The short end of the yield curve is declining, but longer-term rates are not. The US Federal Reserve and the Bank of England both lowered interest rates in December of 2025, with the exception of the Bank of Japan. In the US, this is probably going to pick up speed in 2026 because markets are underestimating how hard Donald Trump and whoever he appoints to lead the Fed will try to lower interest rates to stimulate the economy.

More short-term debt should be issued by governments.

Sovereign debt's average maturity.

Governments' current major issue cannot be resolved by rate cuts alone. The rate at which central banks lend commercial banks extremely short-term funds is directly set by them. The trajectory of short-term bond yields is mostly determined by expectations for this, whereas longer-term yields are more independently set by markets. Therefore, higher long-term yields will raise the cost of interest on public debt even if short-term rates decline.

The new rate increases whenever a bond that was issued at extremely low rates a few years ago needs to be refinanced. As a result, the government is paying an increasing amount of interest. They may attempt to reduce spending in order to reduce debt, but we consistently observe that this is not politically feasible.

Inflating away debt is the obvious solution, but when markets anticipate higher inflation, they will demand higher yields to offset the inflation gains. Although a decade of quantitative easing has shown us how much distortion this causes, central banks could keep yields down by purchasing long-term bonds. Reducing the issuance of long-term debt in favor of short-term debt, which has lower yields, is currently the best course of action. This is what we are witnessing in nations like the United States, the United Kingdom, and Japan (see chart for an explanation of the declining average maturities of outstanding debt). On the other hand, a deluge of short-term debt might cause market turbulence and raise yields. Keep in mind that the Fed started a £40 billion program to purchase short-term bonds earlier this month. It characterizes this as a technical measure to control market liquidity, but don't be shocked if this is merely the beginning of central banks' methodical acquisition of short-term bonds.

This is a scenario. More short-term debt is released by governments. To keep yields low, central banks: a) lower interest rates below inflation; and b) purchase an increasing number of short-term bonds. The yield curve steepens and longer-term yields gradually increase. In 2026, we should begin to learn how this will impact markets and whether it is inflationary.