Ten-year Treasury yields continue to test 5% because of risks around inflation, unsustainable deficits and a scarcity of both goods and capital amid the privately financed artificial intelligence build-out.
Under such conditions, we expect the 10-year Treasury yield will move decisively above 5% in the near term.
But how far will it go? Is 5.5% possible as shortages of oil and distillates out of the Middle East push inflation higher? Or, if inflation expectations increase as a result, is a move to 6% in the cards?
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To understand what could happen, we modeled different yield scenarios and their impact on the economy. First we looked at growth, employment and inflation under the current 5% yield and then did the same under 5.5% and 6% yields should investors push long-term rates higher over the next year.
In those scenarios, the common trends are: growth will slow below the 2% trend, unemployment will rise toward 5% and inflation will remain above 2%. Or, put simply, stagflation-lite would set in.
Whatever the case, central bankers are underestimating the heavy lift needed to achieve the Federal Reserve’s goal of bringing inflation down to its 2% target.
Our modeling that follows is aligned with the Federal Reserve’s most recent Summary of Economic Projections and its interest rate forecast, or dot plot, which implies one more rate hike this year and none next year.
While RSM forecasts that the Fed will lift rates by another 25 basis points this year and most likely again by 25 basis points early next year, whether we get one or two more hikes will not make a material difference in inflation. Either scenario will almost certainly end up as a necessary but not sufficient condition to achieve price stability any time soon.
But further rate hikes will almost certainly be necessary, which will test how much economic pain the Fed will be willing to tolerate and could derail the extraordinary cap-ex supercycle and the accompanying surge in equity valuations.
Given that the Fed does not project the economy to move back to 2% inflation until 2029, a period of immaculate disinflation, where inflation declines without causing a major economic slowdown or a recession, will need to occur.
Such a scenario is not out of the question, as seen in an expectations-augmented Phillips curve in which households and businesses believe that the Fed intends to move inflation back to 2% and then adjust their behavior accordingly.
But that scenario requires a lot to happen. Workers will need to ease their wage demands, and businesses will need to absorb higher input costs and accept thinner profit margins. Only then does the Phillips curve shift downward as inflation eases back to the target without raising unemployment or bringing on below-trend growth.
Is that scenario possible? Yes, but it’s improbable based on our shock model and recent history.
Unless oil prices fall sharply later this year or next, it is highly unlikely that conditions consistent with an expectations-augmented Phillips curve will coalesce.
Model-derived outcomes
The 10-year Treasury yield crossed 5% on Sept. 14, a level it touched only briefly in October 2023 and last held for a full quarter in 2006.
Two days later, the Federal Reserve published a new projection, forecasting two more rate increases this year. In addition, eight of the 17 voting FOMC members forecast another 25 basis-point rate hike next year.
The central bank has embarked on a rate hiking cycle, but will two hikes, or even three, be enough to push inflation back to 2%?
We modeled a serios of shocks through the rate channel to identify the impact on growth, employment and inflation. We then ran the Fed’s own model based on a number of scenarios to estimate the impact on the economy.
Our 2027 model-based projections for growth, unemployment and inflation:
- An increase to 5%: The current increase to 5% in the 10-year yield shaves approximately 0.4 percentage points of growth over the next year. While that will not present a drag in the current quarter, one should anticipate that deadweight to result in a slowing of growth in the final quarter of this year and throughout next year.
- An increase to 5.5%: Shaves two-thirds of a full percentage point in gross domestic product by the end of next year.
- An increase to 6%: Results in a near full percentage point.
- Unemployment: Ends next year at 4.8% in two of the worst scenarios compared with 4.3% in the baseline forecast.
- Inflation: Because the primary factor in rising long-term yields is inflation expectations, actual inflation ends next year higher in every case. In that scenario, the Fed will need to go beyond the two rate increases forecast in the Summary of Economic Projections, and, more likely, beyond the three hikes that the market is pricing in. The core personal consumption expenditures index, the Fed’s preferred inflation gauge, increases to 2.4% should the 10-year rise to 5.5% versus the 2.2% baseline forecast. With the funds rate fixed via the projection through next year, there is nothing other than an extremely unlikely immaculate disinflation to bring inflation back to the 2% target.
The baseline
We build a counterfactual scenario in contrast with the current baseline where yields do not exceed 5% to capture what would happen to growth, employment and inflation if the 10-year yield moves well above 5%.
To do that, we use the model to forecast the economy using data before the third quarter with our assumption that the Fed would hold interest rates steady for all of this year.
This was not only RSM’s forecast but was also the overwhelming consensus before the third quarter.
In this baseline, the 10-year is expected to be around 4.5%, growth ends next year at 2.2%, unemployment is 4.3% and core PCE is 2.2%.
The scenarios
In each one, the Fed follows its projection (two hikes this year, none next year), 50% of the yield’s rise above the yardstick is higher long-run inflation expectations as the 5-year and 30-year increase in line with the 10-year.
1. An increase to 5% that then holds near that level
- Assumption: The 10-year at 5% from this quarter with no material move higher.
- Result: Third-quarter growth is unchanged at 2.4%; the economic drag arrives in the fourth quarter (minus 0.40 points) and next year’s growth is 1.8% versus the previous forecast of 2.2%. Unemployment ends next year at 4.6%; payrolls average 50,000 a month; core PCE 2.4% at end of next year.
2. An increase to 5% that then fades back to 4.7%
- Assumption: The 10-year moves to 5% this quarter, then fades the way past spikes have (keeps 50% of the rise after a year, 21% after two), to near 4.7% by end of next year.
- Result: Growth of 1.9% next year, unemployment 4.5%, payrolls 60,000 a month, core PCE 2.3%. The difference between holding at the 5% level and fading back to near 4.7% shows up in 2028.
3. A increase to 5.5% in the fourth quarter, then it fades
- Assumption: 5% now, 5.5% in the fourth quarter and then fades as growth slows.
- Result: Growth 1.5% next year—about a third of a point less than at 5%. Unemployment 4.7% at end of next year; payrolls average 30,000 a month. Core PCE 2.4% at end of next year; mortgage rates peak near 7.3%.
4. An increase to 6% in the fourth quarter, then it fades
- Assumption: Similar to third scenario with 6% instead of 5.5% in the fourth quarter; one observes a similar easing in market-derived longer-term rates as the economy slows.
- Result: Growth 1.3% next year; unemployment 4.8% at end of next year; payrolls average 12,000 a month; core PCE 2.6%. The 100 basis-point increase roughly doubles the drag on growth.
5. A increase to 5.5% in fourth quarter, 6% in first quarter, then it fades to 4.7%
- Assumption: 5% now, 5.5% in the fourth quarter, 6% in the first quarter, then the same fade from the later peak.
- Result: Roughly the same as Scenario 4 (growth 1.3%, unemployment 4.8%); inflation expectations are still 2.7% at end of next year, the highest of any case.
Source: RSM US, FRB/US model. Growth and payrolls are 2027 averages. The yardstick holds the funds rate; every other case has the Fed’s projection (two hikes in 2026, none in 2027). Fading paths follow the average retracement of the six yield spikes since 1990.
Why the yield rising matters
We built 50% of every yield increase to include higher long-run inflation expectations because of the likely interpretation of the market’s reading of the move higher in market derived long-term interest rates.
In the model, the expectations component of the 5.5% case lifts the 10-year 36 basis points on its own at once and an additional 18 basis points by the end of next year; the term premium supplies the rest.
How long a spike lasts
Our fading paths follow the six episodes since 1990 in which the 10-year rose at least three-quarters of a point in six months—1994, 1996, 2000, 2014, 2018 and 2022. On average, the yield gave back half the rise within three quarters and most of it within two years; only 2022 kept climbing. The size of the move does the damage next year; how long it lasts decides 2028.
Bottom line
Market-determined long-term rates have moved higher and 5% is where the 10-year benchmark yield resides. Together with the Fed’s two hikes, it will shave approximately 0.4 points from growth over the coming year. A move to 5.5% will increase that cost by an additional one-third of a point and will then result in a slower pace of hiring and rising unemployment.
What the yield does to inflation depends on why it is rising: If the market is pricing in inflation, it gets inflation. That is how inflation expectations work, and then the Fed will need to lift rates higher than its current forecast implies.
Methodology
We used the Federal Reserve Board’s FRB/US model to compare alternative 10-year Treasury yield paths against a baseline forecast built from data available through the second quarter of 2026.
Each scenario applies the Fed’s September policy projection and then isolates the effect of different yield levels and persistence assumptions. The yield paths move the broader Treasury curve with the 10-year, and part of each increase is treated as higher long-run inflation expectations to reflect the market’s interpretation of the move.
