Opinions

Yesterday’s NFP report released is important because it tells us that (1) the US economy and labour markets remain firm and (2) the FX market is finally paying attention to US economic performance. We have a USD-positive medium-term view, and the positive overall USD response does not surprise us. In yesterday’s May NFP report, total employment rose 172k, which, along with upward revisions, sent the three-month average to 188k—the best in just over three years. To give a context, the neutral rate for NFP is considered 50k currently. The unemployment rate ebbed just 4bp with the rounded rate holding steady at 4.3%. NFP tell us two facts: 1. The straightforward cyclical story – the US economy and labour market look firm 2. The market reaction to the NFP data. Asset markets (especially the FX market) are beginning to pay attention to economic data, setting aside the last 15 months’ concerns about tariffs, Greenland, oil, Iran, etc. This is reflected in the rise in US real interest rates to their highest levels since June 2025, and the 0.7% increase in the BBDXY after the NFP release. The only way one can counter the rate hike rationale is through the fact that the current pace of unit labour cost inflation in the nonfarm business and nonfinancial corporate sectors is very unthreatening. Markets are now pricing in a full 25bps hike from the FOMC by end-2026, and almost two hikes by mid-2027. So, the question we ask ourselves is: Can the next Fed action be a hike. We tend to think the market has over-responded to the hawkish side recently, after over-estimating how dovish year-end Fed policy would be earlier this year. Incoming Chair Warsh is likely to bring a more powerful dovish voice to the FOMC to replace outgoing Governor Miran, and Warsh is likely to have some allies on the Board and among some regional bank presidents, even as others (not all of whom are voters this year) have turned more hawkish. We expect it will be a more gradual process to reach consensus on the FOMC to hike rates, although we continue to see some chance it could occur by year-end. The jury is still out.

With Iran conflict dragging on more than two months, US bond markets are now stuck in a tight range. 10yr UST is hovering in the range of 4.30-4.4 and rate cuts or rate hike expectations are hovering around 0 by end CY26. Crude oil continues to drive the near-term intraday moves for various assets, and the pullback in the oil price this week has contributed to the recent widening in swap spreads and the decline in implied rates vol. 10y swap spread has widened by as much as 4bps over a 1wk rolling window, which represents one of the sharpest outperformances in Treasuries relative to swaps in recent years. We believe Fed being stuck in a brittle job environment and higher core PCE, rate cuts are out of window. But rate hikes too are distant as job environment is too shaky to be considered solid. Hence markets might be stuck around pricing in +/-10 bps of cuts or hikes by end CY26. Hence carry strategies and received vol positions make more sense than any duration exposure. 1yr-1yr US SOFR is currently at 3.72 where we like to receive half risk and another half risk at 3.90. Stop loss to this view is 4% and profit target is 3.5%. We also like to receive 2*10 US SOFR steepeners around current levels of 22 for an eventual profit target of 40 with stop loss around 14 levels. Next week we also have the Treasury refunding auctions with the 10y new issue scheduled on the same day after CPI. In recent years, there has been a notable tendency of the 10y refunding auctions to perform more poorly in comparison to the reopenings. Given that the foreign takedown for the 10y auction has been trending lower since peaking in January, we are mildly cautious that the upcoming 10y refunding could face some headwinds. On Tuesday’s CPI itself, we see core CPI inflation as likely accelerating to 0.29% m-o-m in April from 0.20%, largely due to technical factors associated with rent-related components. Our forecast translates into a y-o-y change of 2.8% up from 2.6% in the previous month. It is worth noting that NSA headline CPI has generally come in below the fixings market-implied levels since the start of 2025. Even last month after the oil spike due to the Middle East conflict, actual NSA headline CPI came in below the extraordinarily high market expectation. Currently the CPI fixings market is implying 0.78% MoM headline. On the short end, repo markets this week continued to show signs that liquidity in the system is plentiful. We think the recent move lower in repo has been a product of negative T-bill supply in March and April, as well as continued (albeit slower) reserve management purchases (RMPs). We think the next catalyst for a move higher in SOFR could come in July as Treasury warned that they will be increasing T-bill sizes “across the curve” once more, and that the TGA balance could reach $1tn towards the end of the month.

Post the Iran event, DM rates have dramtically repriced. In the four weeks since the bombing began in Iran, 10-year US treasury yields have climbed 48bp, from 3.94% to 4.42%. The 10yr UK gilts have climbed up by 75 bps and the 10yr German Bund yields have climbed up by 45 bps. In UK pre-Iran event rate cut pricing of 50 bps in REMCY26 has now changed to almost 3 hikes of 25 bps each in REMCY26. Similarly in EU, status quo for REMCY26 pre-Iran event has changed now to 3 hikes of 25 bps each in REMCY26. The current violent repricing seems to be a result of concentrated received positioning in a market priced for cuts and the scars of underestimating the 2022 inflation shock. Compared to other asset classes such as equities/fx, rates IVs have shot through the roof. The big question in those assets is whether we see a deeper and broader drawdown because the energy disruption from the Strait of Hormuz is longer-lasting and the market moves to worrying about severe growth downside. That would put more outright pressure on equities and EM, may provide some relief to the rates complex, and boost the Dollar further as it cuts against the prevailing trend of more globally diversified allocations. For 10yr UST yield fair value, we use the “golden rule” of French Nobel laureate Maurice Allais. The basic idea is that over the medium to long term, nominal GDP growth is a decent proxy for return on invested capital. Therefore, in any economy bond yields should tend to converge with the structural growth rate of nominal GDP. For US the 7 year moving average of annual nominal GDP growth is 5.9% against current 10yr UST level of 4.45%. But does that mean the 10 yr UST yields are too low? It depends upon how inflation actually shapes up in next 1-2 years. If inflation cools back to Fed's 2% target, then the fair value of 4.4% is justified. But if inflation were not to cool and remain elevated then an upward march in long end yields is assured. The last time these two scenarios—diverged as much as today was in the early 1970s. For several years, the bond market couldn’t make up its mind which scenario was right. But following the Yom Kippur War and the Arab oil embargo of October 1973, the bond market concluded the first scenario—higher inflation—was correct. But the story flips on the short end. Market pricing of many front ends now looks quite asymmetric across several scenarios—we think the hike risk priced in the US, and multiple hikes priced in Europe will prove too hawkish. From a fundamental standpoint, this repricing may be reflecting some scar tissue from the inflationary episode of 2022. And G10 central bankers’ focus on indirect and second-round effects and the risk of un-anchoring inflation expectations have clear echoes of that period. And if it were a growth shock as we expect it to be soon, the rates hikes currently being priced in might need to moderate. To summarise, while the long end rates have higher probability to remain elevated due to inflation expectations as well as probable fiscal measures needed to support growth, the short end rates in DM look attractive at current levels to receive for fading out the current rate hikes being priced. Hence, 2*10 curve steepeners as well as 1yr1yr rates look attractive to receive at these levels.

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.