The rise in real yields because of government deficit spending, alongside ongoing huge demands for AI investment, are underpinning the rise in interest rates, says Ashok Bhatia, chief investment officer at Neuberger, an investment management firm with more than $600 billion in AUM.

Speaking with Lisa Lee on the latest episode of Credit Exchange, Bhatia says that real interest rates are the key to understanding the current bond market landscape.

“The bond market’s really relaxed about intermediate term, 5-to-10-year inflation rates. It is just telling you there is not a problem,” he says. “[But] the big change that happened in the bond market is real interest rates. If the 10 -year today is about 4.7%, the market tells you inflation will be about 2.2%. That’s a 2.5% real yield. So that’s up from basically zero. [Historically] it’s probably a little bit on the cheap side.”

But he notes that if the real interest rate climbs to 3% or above, that’s when the economy can be in strife.

“At that point, if an economy is growing at 2-2.5%, and you think about the real cost of capital at 4%, you’re upside-down on that,” Bhatia says. “And it’s often when financial accidents and problems happen.”

Bhatia contends that for the bond market, it is suddenly starting to feel that a horizon which had previously felt distant, is now “on a horizon that we need to invest on.”

For Bhatia, who is also Neuberger’s global head of fixed income, aggressive rate hiking by the Fed at this point would represent “a policy error”, although a single rate rise would not be the end of the world. “But if the Fed started taking the policy rate up 100 basis points… the market would conclude that is really not necessary. It would also probably start putting real interest rates into more of a danger zone [and] would probably have some repercussions for the dollar.”

Bhatia also discusses dangers on the horizon in the bond market, the ongoing impact of the Iran war, and the distinctive characteristics of working for an employee-owned firm.