Opinions

We see CY2026 as an year where thought the dated UST supply will reduce, the net duration supply will increase in USTs. This will lead to curve steepening. We expect the 2-30 spread to increase to 165 bps from the current 125 bps. This is happening because Treasury strategy is shifting toward T-bills, with net note/bond issuance falling about 25% y/y amid higher redemptions and renewed Fed purchases. We expect net issuance of notes/bonds to investors to fall to $1.2trn, from $1.7trn last year, with net T-bill issuance rising from $350bn to $700bn. On the investment grade issuance side, we expect 1.6 TN USD of gross issuance & .67 TN USD of net issuance. The increase in net supply is largely a non-financial story, and the biggest upside risk is AI hyperscaler capex. In the High yield space, we can expect .35 TN USD of gross supply. In the Leverage loan space, we can expect .5 TN USD of gross supply. To summarise, We see more of curve steepening due to net higher duration supply as well as elevated net IG supply. This implies pressure on yields to rise specially if future macro data does not support further rate cuts. We don’t expect any rate cut till May when Fed Chair Powell term ends. We still expect 2 cuts of 25 bps each in June & Sep. We have been bearish on 10yr UST since 9th Nov as below recommendation: https://macro-spectrum.com/trade-recommendation/sell-10yr-ust At the time of reco, the 10yr UST yield was at 4.09 and we are targeting 4.30 levels. On Friday it closed at 4.22%.

We believe there is a reasonable possibility for 10yr UST yields to dash to 4.5% levels in CY26. Our own sense is we will finish CY25 for 10yr USTs at 4.15% & 4.25% in CY26. But in this opinion piece we explore various factors which can pull 10yr UST yields towards 4.5% levels from current 4.1% levels. The key drivers would be a hawkish shift in Fed expectations or fiscal fears but a combination of the two would likely be required. For the 10Y to reach 4.5% purely via the Fed pricing channel would likely require no rate cuts beyond Dec cut and the market to start viewing the next policy move as more likely to be a rate hike. If the fed funds target range is at 3.50-3.75%, then 1Y1Y USD OIS is likely to be around 3.60- 3.65%. Based on the relationship between 1Y1Y and the 10Y yield so far this year, that would push 10Y to around 4.45%. This will require a mix of strong growth & elevated inflation in US. This could be quite realistic as US productivity growth is the highest amongst all DMs. There is a significant potential for a further late-cycle pick-up in US productivity growth and historically such a productivity surge tends to go hand-in-hand with solid job growth. We believe the U.S. is on the cusp of another surge in labor productivity that should drive greater economic efficiencies, boost real wages, expand corporate profitability and maintain America’s global competitiveness relative to the rest of the world. if a high growth scenario emerged in tandem with still-sticky (or even rising) inflation, then the market would need to pivot towards pricing in rate hikes, and possibly also a higher r* (natural rate of interest) which would likely boost long-term real yields. We also believe soon there will be a flare up in the term premium demand for long end USTs. The 10Y term premium remains c.100bps below its long-term average, suggesting further upside potential. We list several factors such as US Supreme Court ruling out Trump's tariffs, Trump's recent talk of tariff dividends to the tune of $2000, UST likely increase in dated supply by end CY26, pressure from EURO rates due to Dutch pension reforms as well as higher German fiscal spending, pressure from JGB rates due to fiscal expansion as well as rate hikes leading to repatriation of UST investments to JGBs & the latest Hassett factor. Kevin Hassett selection might imply loss of institutional credibility for Fed considering his well known stance on rate cuts. This might further push inflation expectations higher as well as term premiums. Hence we conclude that It is entirely possible that 10yr USTs test 4.5% in CY26 based upon a host of factors as highlighted above. The risks to the above view is a sustained fall in crude towards $50 levels OR AI theme suddenly breaking down leading to a severe risk off. We believe as a prudent risk management tool, we should be cognisant of duration risk in light of above factors.

The Dutch pension fund (PF) system is in the middle of a transition phase, from Defined Benefits (DB) to Defined Contributions (DC), with the transition impacting 99% of members between Jan25 and Jan28. In the new system, PFs will likely need less duration, having in particular to reduce exposure to (ultra) long-dated swaps & bonds as young members will be assigned low risk-free exposure. This suggests a likely reduction in investments in long-term (≥25 years) government bonds and interest rate swaps under the new pension contract. We estimate that funds will reduce their holdings in government bonds and interest rate swaps with a maturity of 25 years and longer by roughly €100-150 billion. By comparison, €900 billion is outstanding in (semi-)government bonds with such maturities, and the net position of interest rate swaps is over €300 billion. In the post covid period, Dutch PFs increased their interest rate hedging to protect their funding positions. It is the duration of the swaps portfolio that appears to have risen meaningfully, from the €500-600bn in pre-COVID times, to possibly as much as c.€900mln/01 currently. Post the reforms, Dutch PFs will invest less in bonds due to reduced DV01 needs as well as removal of constraints on capital charges. We estimate that duration needs would be reduced by €50-140mln/01 for the PFs in the Jan-26 wave. We believe that for the funds switching in Jan-26, the extent of the increase in the received swaps positions seen over the last few years will mean those are likely to be the first unwound. Market Implications: Both the scenario of reduced govt bond holdings or that of a barbell in highly liquid & more risky investments could drive a reduction in Dutch govt bond holdings. We also look for an initial out performance of bonds versus swaps in the long-end of the curve as the focus of initial unwinds centers on swaps. With the first big wave seeking to unwind their hedges en masse in end Dec when liquidity is typically poor, investment banks and brokers may struggle to match up sellers and buyers, freezing up the system. The supply-demand imbalance for longer-dated swaps is already significant. With a pipeline of pension funds needing to unwind swap positions, market players such as hedge funds seeking to profit could let this play out before stepping in to take the other side of the trade. That could lead to a rapid steepening in the curve. Hence, we remain cautious on long end DM yields especially EGBs going into year end.

Bond investors are doubting the UK government’s fiscal credibility after reports that Chancellor of the Exchequer Rachel Reeves will drop a widely-expected increase in income tax in this month’s budget. UK Gilts slumped by 13 bps early on Friday as investors questioned how she would fill a large hole in the Nov. 26 budget without the tax hike. The market then reversed course to ease losses on a Bloomberg report that improved economic forecasts enabled the U-turn, but the flurry of headlines left traders struggling to get a grasp on the risks. Our own take is that Rachel Reeves might be actually looking at a smaller fiscal hole to the tune of 15-20 BN GBP. So yes she will still do tax hikes but these will be smaller tax/revenue raising efforts. Fiscal tightening is expected to weigh on GDP by 0.25-0.4% at peak between mid-2026 and early 2028, but easing monetary policy should offset some of this drag. While the autmn budget on 26th Nov might have mixed implications for UK equities, we see UK 10 year gilts as attractive at current levels of 4.58. We do not expect it to breach 4.60-4.65 levels post the budget presentation. In fact we believe these are attractive levels to buy 10yr UK gilts due to recent macro UK data. Disinflationary progress in price data has been reinforced by a deterioration in labour market quantities, which typically provide a reliable forward-looking signal for inflationary pressure. We expect 10y Gilt yields reaching 4.0% next year and 10y Gilt – Bund spreads falling to 100bp by the middle of next year from current levels of 186 bps. In summary Rachel Reeves is definitely not the next Liz Truss & we see current UK gilt elevated levels as an attractive opportunity to initiate long positions.

Despite widespread worries following the passage of the One Big Beautiful Bill Act (OBBBA), the US Treasury market has been notably resilient. 30yr USTs have outperformed all DM long end bonds. Yet we believe this out performance might grow further. We believe markets are yet not factoring the far better US fiscal profile. Current fiscal and monetary policy outlooks suggest budget deficits are likely to dip to 5.5-6.0% of GDP, while many had expected a rise to 7-8%. The 10y forward debt/GDP ratio is close to 116%, compared with the 130% that was looking likely earlier this year. The current tariff revenues are likely to generate 300 BN USD per annum. Even with the OBBBA in place and before accounting for the year-to-date decline in intermediate yields, the 10y forward debt/GDP ratio would be closer to 123%, versus 130% if only TCJA cuts were extended. The resulting annual primary deficits should stay around $900bn for the years to come and fall as a share of GDP from about 3.6% in 2024 to roughly 2.3% in ten years. Hence, the net effect of all the policies put in place is fiscal consolidation to the tune of 1pp of GDP. This is unusual, as budget deficits tend to widen when one party controls all branches of government. T-bill yields, which account for 20-25% of outstanding debt, are priced to decline to about 3% within a year, versus prior expectations that they would stabilize at 4%. Issuance-weighted average yields on notes and bonds have declined from 4.5% to 3.8%, despite the economy largely expected to end up in a similar place. Most Treasury issuance is in the belly of the curve; 2-7y issuance accounts for 75% of total new issuance. The treasury relatively short WAM of outstanding debt, at about six years underscores the above fact. We expect the Treasury to continue to increase the proportion of T-bills in its issuance mix, while keeping sizes of notes/bonds unchanged, even next year. If coupon auction sizes remain unchanged through 2027, the T-bill share could still reach roughly 24%, below the pre-Global Financial Crisis (GFC) average of 25%. The decline in interest rates has shaved off another 1.3pp of GDP from annual deficits. The Treasury has an objective to "fund the government at the least cost to the taxpayer over time. But 30y yields are trading at 4.75%, back to the levels that prevailed pre-GFC, despite estimates of the neutral rate having fallen almost 150bp since then to about 3.1%. As a result, the 30y survey-based term premium is about 165bp. To put that in perspective, since 2022, it has averaged 125bp, post-GFC to pre-COVID 1bp, and pre-GFC (from early 2000 to 2006) 70bp. An elevated term premium at the long end argues for relying on the front end to finance deficits, rather than further out the curve. As a result, the Treasury should be in no rush to increase auction sizes of nominal notes and bonds. The share of T-bills would rise from 21.4% at YE25 to about 22.2% by YE26 and 23.7% by YE27. This is still below the pre-GFC average. We also expect the Fed's QT to end by March 2026 and for it to become a buyer of USTs as it reinvests mortgage pay-downs into the Treasury market and eventually expands the balance sheet in 2027 to keep up with rising demand for reserves. (Bank reserves have currently fallen below the crucial 3TN USD level which is traditionally considered the ample reserve level) Some also argue that elevated term premia reflect nonfiscal risks such as policy uncertainty, threats to Fed independence, or diversification away from USD assets. However, this view is inconsistent with market- and flow-based indicators: implied rate volatility remains close to historical lows, 5y5y CPI swaps show little worry about the Fed's inflation credibility, and foreign and domestic private inflows into Treasuries have remained robust. To summarise, markets have yet to internalize the US fiscal developments and hence we expect 30y yields to decline further, to 4.35% from the current 4.7%.

Japan is in a refunding month, and is projected to have the largest duration extension (+0.15y) complimented by a rebalance from equities towards bonds. The US (+0.06y) and the EU (+0.08y) are expected to see a duration extension complimented by rebalance towards bonds. The UK is mixed, with a duration contraction (-0.01y) and rebalance from bonds towards equities on a monthly basis, however on a quarterly basis equities have outperformed bonds so the rebalancing is in the other direction. For UST Aggregate Index: +0.06y, September is a non-refunding month with a duration extension +0.06y, which is below both its September average over the past three years +0.07y, and its 12-month average +0.07y. The UKT index should see a duration change of -0.01y, below both its September average +0.21y, and its 12-month average +0.03y. The JGB Index (I38292JP Index) extension projected for the refunding month September is +0.15y (September 2024 was +0.22y). The EGB Index duration change is an estimated +0.08y, above its September avg. of +0.05y, and roughly in-line with its 12-month average +0.08y. On a monthly basis, equities have outperformed bonds in the US, EU and Japan, indicating a month end rebalance from equities towards bonds. This is reversed in the UK, with a rebalance towards equities from bonds. On a quarterly basis, equities have outperformed bonds in the US/EU/UK/Japan, indicating a month end rebalance from equities towards bonds.