Opinions

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.

When we started the year CY25, it looked like UST yields were headed for a large rout compared to G7 peers. Fiscal worries, fed independence, policy flipflops were the buzzword for selling USTs. But mid-way down the year, USTs are now outperforming most of the G7 peers. Both in the 10yr and 30yr space, USTs have outperformed German bonds, UK Gilts, French OATS and JGBs. We believe US fiscal worries are looking less troublesome considering 20-25 BN USD per month tariff revenues. Also Fed might be forced to cut fast to neutral rate level of 3% by March 2026 as employment mandate takes precedence over it’s price stability mandate. Despite concerns over Fed independence and fiscal pressures, US bond markets remain relatively stable, with the US viewed as a safe haven and the "best house in a crumbling neighbourhood". Against the backdrop of turmoil in other debt markets and an overhang of fiscal and economic pressures, the US bond markets might continue to stand out as remarkably stable. We also believe that current US administration stated goal is to bring US rates lower. Hence treasury secretary Bessent might ensure through low duration supply & higher tbill supply that USTs remain well behaved. He has jaw boned on all occasions US yields were rising and he has been till date efficient in this approach. On the other hand, Germany’s stated goal of increasing fiscal to fund defence expenditure is well known and hence the rise in bund yields. Also what is more problematic is the consistent French government stability issues & UK debt worries. In Japan political uncertainty, a reluctant BOJ, sustained high inflation are leading to sustained high JGB yields. Without a move from Japanese lifers bringing back their investments in to JGBs we don’t see a way out of current up trend in JGB yields. For all above reasons we remain bullish on long end USTs against long end G7 peers. Currently the spread between 10yr UST & 10yr bunds is 142 bps. We believe this spread might be ticking down to sub 100 levels sooner than later. Europe fiscal expansion, defence spending, political issues in France etc are multiple headwinds for bund yields. On the other hand, forthcoming rate cuts in US, a favourable duration supply from US treasury and a likely reduction in QT further as bank reserves go down will enable USTs to outperform it’s G7 peers at least till Q1CY26. The risk to our view if US supreme court overturns Trump’s tariffs in which case tariff revenue disappears, US growth turns solid with less scope for rate cuts.

We are fast approaching an environment where we might see significant receiving in US rates across the curve. Not only is the macro environment suitable for US rates after Powell’s dovish commentary yesterday at Jackson Hole, next few weeks will see data points specially +ve for US bond yields trading significantly lower. We start with the month end expected index extension & month end rebalancing (Equities to bonds) for August. The US refunding month of August produces a large +0.12y duration increase (for the US), complimented by a bond/equity rebalance favouring bonds. In US, August is a refunding month, with a typically large duration extension +0.12y, which is above both its August average over the past three years +0.11y, and its 12-month +0.07y. Also on a monthly basis, equities have outperformed bonds in the US, EU, UK and Japan, indicating a month end rebalance from equities towards bonds. Then we have the August NFP (Non-Farm Payroll) coming on 5th Sep which can be sub 50k. In August, continuing claims have remained high at 1950-1972k which are near Sep’21 highs. We believe we are fast approaching a rapidly weakening employment scenario where monthly NFPs can fall below 0 by Oct. (i.e. the Sep reading of NFP might be -ve) Then on 9th Sep we have the upcoming benchmark revision to nonfarm payrolls (NFP), which will likely lead to a large negative revision. This data will be released when the FOMC are in their blackout period. Fed Chair Powell alluded to this data in his JH speech yesterday. We estimate the US economy needs to add ~75K new jobs each month in order for the unemployment rate to hold steady (i.e., the breakeven pace). A number below this signals an uptick in the unemployment rate is likely. Our expectation is for the unemployment rate to continue to move higher, reaching 4.7% by year-end. Fiscally also new tariff revenues are creating large buffers for deficit management. CBO (Congressional Budget Office) in it’s 19th Aug report stated that they estimate that the effective tariff rate for goods imported into the United States has increased by about 18 percentage points when measured against 2024 trade flows. They project that increases in tariffs implemented during the period from January 6, 2025, to August 19 will decrease primary deficits (which exclude net outlays for interest) by $3.3 trillion if the higher tariffs persist for the 2025‒2035 period. By reducing the need for federal borrowing, those tariff collections will also reduce federal outlays for interest by an additional $0.7 trillion. As a result, the changes in tariffs will reduce total deficits by $4.0 trillion altogether. Summary: We see a large 20 bps movement in US rates across the curve by 10th Sep. The short end might see even 30 bps down ward movement if NFP and the upcoming benchmark revision data surprise on the downside. We continue to recommend staying received on 2yr US rates as well as 1yr-1yr US SOFR. By 9th Sep, we are looking for sub 3.5 levels on 2yr UST (CMP 3.7), 3.55 on 5yr UST (CMP 3.76) and 4.10 on 10yr UST (CMP 4.25). On the 1yr-1yr US SOFR position, we are looking for 2.90 levels (CMP 3.08). Markets are pricing in only 54 bps of cuts for REMCY25 which can easily change to 75 bps if our view on Aug NFP and benchmark revision data is correct.