According to a report, Citadel Securities believes the main driver behind the recent US Treasury selloff and the rise in yields to multi-decade highs is not heightened market fears of worsening inflation, but rather sustained strong US economic growth, combined with AI investment and government deficits that are intensifying the competition for capital.

The firm points out that even if inflation eases in the future, it may not be enough to push Treasury yields significantly lower.

Nohshad Shah, head of fixed income sales for Europe, the Middle East and Africa at Citadel Securities, noted in a client report on Monday that the rise in the US 10-year Treasury yield in September came almost entirely from higher real yields, while market inflation expectations remained relatively stable overall.

This means investors are reassessing the strength and sustainability of US economic growth and demanding higher inflation-adjusted returns, rather than simply seeking higher yields to guard against inflation risk.

US Real Yields Climb as Strong Economy and AI Investment Intensify Competition for Capital

Shah said the US economy is currently supported by fiscal easing, relatively accommodative financial conditions and large-scale AI investment, all of which are pushing real interest rates higher.

He noted that the market is "repricing the strength and sustainability of economic growth, and the real interest rate level needed to accommodate that growth." In other words, investors are demanding higher post-inflation real returns, not simply more compensation for inflation risk.

This logic is also closely tied to the current AI investment boom. Higher potential investment returns encourage tech companies to keep expanding AI infrastructure spending, but at the same time, financing these investments, together with the US government's persistent fiscal deficits, means the competition for funds between the private and public sectors is intensifying further.

In this situation, the market needs more savings to meet funding demand, or must attract capital through higher real yields. Therefore, even if inflation pressures gradually ease, Treasury yields will not necessarily fall sharply as a result.

Shah pointed out that this is precisely why he is unwilling to conclude that Treasury yields have peaked simply because inflation is coming down. However, he also noted that if yields are to rise significantly further from current levels, a new repricing of economic growth, the policy outlook or the term premium would be needed.

About Four Rate Hikes Expected Over the Next Year Called "Reasonable" as Inflation Stickiness Remains a Concern

On the monetary policy outlook, Shah believes that given still-sticky inflation and resilient US demand, the market's current expectation of about four rate hikes over the next 12 months is "reasonable."

He is particularly concerned that fiscal support and strategically important AI investment may make some demand less sensitive to interest rate changes. This means that even if borrowing costs rise, some investment and spending may continue to expand, weakening the dampening effect of higher rates on economic demand.

At the same time, deglobalization trends and supply constraints in the real economy may also limit the room for further declines in goods prices, making it difficult to fully offset persistent inflation pressures in the services sector.

Therefore, in Citadel's view, the interest rate environment currently facing the US economy cannot simply be understood as "high inflation driving yields higher." The funding demand created by economic resilience, fiscal expansion and AI capital expenditure is becoming an important force determining the level of real interest rates.

Rising Financing Costs Mean the AI Investment Boom Will Also Face a Test

It is worth noting that the AI investment boom pushing real yields higher may itself be affected by the high-rate environment. Shah estimates that about one-third of large cloud computing companies' capital expenditure this year was financed through debt.

With real interest rates and financing costs continuing to rise, how much cash flow AI projects can generate in the future will become increasingly important.

This means that the sheer scale of AI investment is not enough to sustain the current boom over the long term, and companies will ultimately need to prove that these capital expenditures can generate sufficient economic returns.

Against this backdrop, Shah reiterated a preference for large cloud computing companies such as Microsoft (MSFT.US) and Google parent Alphabet (GOOGL.US, GOOG.US). These companies' business models do not rely solely on selling access to AI models, but have broader businesses and monetization channels, giving them stronger support in an environment of rising financing costs.

Shah said the AI boom can support a higher real cost of capital, but "cannot make that cost irrelevant."