Long-term bond yields are driving borrowing costs

Fiscal spending financed heavily by debt can come back as higher interest bills. The key question is not when the policy rate moves but whether balance sheets can withstand higher long-term yields.

Lee Yoon-soo

The author is a professor at the Graduate School of International Studies at Seoul National University.

Rising tensions in the Middle East have lifted oil prices and revived inflation worries, and long-term government bond yields have reacted accordingly. But the movement in long-term rates should not be treated as a simple “oil shock.” Mortgage rates and corporate bond yields, the financing costs that households and companies actually face, tend to be more sensitive to long-term sovereign yields than to short-term policy rates.

Cranes loom over the construction site of the U.S. Federal Reserve headquarters amid renovations of the building in Washington on Jan. 12. [REUTERS/YONHAP]

Markets still focus on policy-rate decisions by the Bank of Korea (BOK) and the U.S. Federal Reserve. Investors watch for when the Fed might resume cuts and how long the BOK will keep its benchmark rate on hold. Many borrowers expect that if policy rates fall, or at least stop rising, their interest burden will ease.

That expectation can be an illusion. The policy rate is a benchmark for very short-term funding. Most lending rates and corporate funding costs are priced off longer maturities and respond more to long-term government bond yields. When long-term yields rise, loan rates do not fall easily, even if the policy rate stops moving.

Two points matter. First, higher long-term yields are not a sudden event but a structural trend built over years. Second, even as major central banks discuss ending the high-rate phase and consider pauses or cuts, long-term yields have increasingly moved separately from policy rates.

A useful reference is the mid-2000s “Greenspan's Conundrum,” when U.S. policy rates rose, but long-term yields stayed low as capital from emerging Asian economies, including China, flowed into U.S. Treasurys. It showed that long-term yields can diverge from policy rates when global capital flows and bond market supply and demand shift.

Today, the world is seeing the reverse. Central banks discuss pauses or easing, but long-term government bond yields have risen again. Policy rates may “stop,” but investors are demanding higher interest to lend for the long run.

This divergence is visible in ultralong yields. In the United States and Germany, 30-year yields have climbed even after policy rates began easing from their peaks in 2025. Policy rates are on hold or falling, while long-term yields are rising.

This cannot be explained simply by whether a central bank has cut or hiked. A long-term yield reflects expectations for future short-term rates but also includes compensation for tying up money for decades — the term premium. If investors demand a higher premium because fiscal deficits widen, uncertainty rises or major holders reduce purchases, long-term yields can rise even without a change in the policy rate.

The United States illustrates the fiscal channel. Postpandemic fiscal spending expanded sharply, and Treasury issuance surged. The U.S. Congressional Budget Office projected large deficits and quickly rising net interest costs in 2025. When markets anticipate a large wave of supply that must be absorbed, they may insist on higher long-term yields.

Across major economies, spending has grown faster than revenue, keeping deficits persistent and placing steady pressure on long-term bond markets. Long-term yields have become more sensitive not only to growth and policy expectations but also to how much debt markets must digest.

Korea should not assume it is immune. Since around 2019, revenue conditions have weakened, but mandatory spending pressures linked to aging and welfare transfers have increased. The gap between total revenue and total expenditure, sometimes described as “alligator jaws,” can raise future interest costs and crowd out other priorities.

Bank of Korea Gov. Rhee Chang-yong presides over a Monetary Policy Board meeting at the Bank of Korea headquarters in Jung District, central Seoul, on Feb. 26. [JOINT PRESS CORPS]

The mechanism is straightforward. Larger deficits mean more bond issuance. As supply increases, bond prices face downward pressure, and yields rise. Higher long-term sovereign yields tend to push up bank bond and corporate bond yields. Even if the BOK holds its policy rate steady, household loan rates and corporate financing costs may not fall.

Pressure also comes from outside the central government bond market. Market estimates suggest total issuance of public enterprise bonds this year could exceed 100 trillion won ($68.3 billion). Even if Korea Electric Power bonds slow, other state entities, such as Korea Land and Housing and the Korea Expressway Corporation, may borrow more. Add industrial finance bonds, capped at 15 trillion won to support advanced strategic industries, and supply in high-grade credit can tighten further.

Because government bonds, public enterprise bonds and policy bank bonds share much of the same investor base, heavier issuance can spread upward pressure across market rates through a crowding-out effect. In that setting, monetary policy has less visible control than in the past. Even while the BOK keeps its policy rate on hold, yields on five-year high-grade bank bonds linked to fixed mortgage rates and on 10-year government bonds have tilted upward again.

Fiscal spending financed heavily by debt can come back as higher interest bills. The key question is not when the policy rate moves but whether balance sheets can withstand higher long-term yields.

This article was originally written in Korean and translated by a bilingual reporter with the help of generative AI tools. It was then edited by a native English-speaking editor. All AI-assisted translations are reviewed and refined by our newsroom.