An analysis from Guolian Minsheng Macroeconomics suggests that U.S. Treasury yield movements in the first half of the year were driven by a "policy rate repricing" based on fundamentals, while the second half has shifted to a "fiscal risk plus supply-demand imbalance" dynamic that is pushing term premiums sharply higher. Expanding deficits, foreign investor selling, and a "crowding-out effect" from AI financing are creating structural upward pressure on long-end yields, making a bear-steepening yield curve the dominant theme as the pricing system for Treasuries undergoes a structural transformation.
The accelerated rise in U.S. Treasury yields this year has once again become a focal point for global asset pricing. As the risk-free rate, which serves as the anchor for global financial assets, has surged upward, it has not only directly compressed equity valuations but has also triggered profound adjustments in cross-asset allocation. During this process, the negative correlation between U.S. stocks and Treasuries has re-emerged after being temporarily broken, pushing global financial market volatility to elevated levels.
However, beneath the surface of the rapid increase in Treasury yields, the core factors driving this rally appear to be changing. In the first half (through the end of June), the market primarily priced in monetary policy shifts driven by economic recovery and an energy shock: Fed policy expectations quickly reversed from pricing in one to two rate cuts for the full year to pricing in rate hikes, causing short-end yields to rise rapidly and converge with long-end yields, creating a classic "bear-flattening" yield curve.
But entering July, with weakening fundamentals and the Fed's hesitation on rate hikes, the upward momentum on the short end has gradually slowed. In contrast, long-end yields have accelerated higher. The trend of a steepening yield curve has continued to strengthen, with term premiums taking over as the core driver of long-end yield increases. We believe this shift may indicate that the pricing framework for the Treasury market is moving away from a model dominated solely by policy rate expectations, toward a multidimensional pricing system driven by the resonance of "fiscal risk premiums, supply-demand mismatch concerns, policy uncertainty, and long-term inflation risks."
Against this backdrop, the upward pressure on long-end yields and the steepening of the yield curve are likely to become core market themes for the second half of the year.
What Was the Treasury Market Pricing in the First Half?
How should we understand the driving forces behind the rise in Treasury yields since the start of the year? Using a classic rate decomposition framework, nominal U.S. Treasury yields can be broken down into expected short-term real rates, forward inflation expectations, and term premiums (which include real term premiums and inflation risk premiums).
1) Expected short-term real rates reflect the market's consensus view on the Fed's medium-term monetary policy path and the long-term equilibrium real rate. This is directly linked to the potential growth momentum of the underlying economy (such as labor productivity and return on capital) and the pace of the Fed's policy pivot. 2) Forward inflation expectations represent the financial market's assessment of medium-to-long-term price stability and the credibility of the Fed's inflation targeting. 3) Term premiums are the additional risk compensation investors demand for bearing the future uncertainty of holding long-term bonds (such as interest rate and inflation uncertainty, supply-demand imbalance risk, and fiscal issuance pressure).
It is not difficult to see that the core driver of the first half's Treasury yield increase came from expected short-term real rates. According to the DKW model's decomposition of Treasury yields, in the first half (through June), the 10-year Treasury yield rose by 23 basis points, with expected short-term real rates contributing about 15 basis points, or roughly 65% of the nominal yield increase. Forward inflation expectations and term premiums each rose by only about 4 basis points, contributing a combined 35%.
Specifically, after the Iran conflict, the drivers of Treasury yields exhibited clear phase shifts: The first phase (the geopolitical conflict escalation period, from the Iran conflict outbreak to mid-May) saw a resonant rise in all three factors. The sudden escalation of the Middle East situation pushed up commodity prices like crude oil, intertwining geopolitical uncertainty with supply-side inflation risks, causing inflation expectations and term premiums to spike in the short term. At the same time, resilient U.S. economic data led the market to further reduce rate cut expectations, pushing expected short-term real rates higher. The combined effect of these three factors drove the 10-year Treasury yield sharply higher.
The second phase (the geopolitical risk abatement period, from mid-May to the end of June) saw inflation expectations and term premiums recede, with real rates alone supporting elevated levels. As the Iran situation eased marginally and crude oil prices fell significantly, the inflation expectations and term premiums that had been priced in were quickly erased, returning to pre-conflict levels by the end of June. However, supported by the Fed's hawkish "Higher for Longer" stance and expectations of a "no-landing" economy, expected short-term real rates remained elevated, serving as the core foundation for the ultimately higher midpoint of first-half Treasury yields.
In summary, the first half of the Treasury market was more of a "policy rate repricing" driven by fundamentals. The market largely revolved around repricing the policy rate based on the "economic resilience—delayed rate cuts" narrative, a classic fundamental-driven logic. During this phase, while inflation expectations were volatile due to geopolitical factors, they remained well-anchored overall. The supply-demand imbalance's squeeze on term premiums had not yet become a market dominant, and the yield curve mainly exhibited a "bear-flattening" pattern, with short-end rates rising to catch up with long-end rates.
What Is the Core Contradiction in the Treasury Market for the Second Half?
However, entering July, the logic driving Treasury yield increases has seen a shift, concentrated in the bear-steepening of the yield curve. Term premiums have taken over from expected short-term real rates, becoming the core driver pulling long-end Treasury yields higher.
First, the slowing economy and the Fed's hesitation on rate hikes have led to a decline in the momentum of short-term real rate expectations. As macroeconomic indicators like non-farm payrolls, inflation, and GDP show signs of marginal weakening, coupled with the Fed's prudence and hesitation on the policy rate path, the market's momentum to further raise rate hike expectations has weakened. Since July, the pull effect of expected short-term real rates on long-end yields has diminished significantly, with overall upward momentum slowing. However, long-end nominal rates have surged unilaterally, driven by term premiums, causing the yield curve to steepen rapidly. Since July, the 10-year Treasury yield has risen by about 30 basis points, with almost all of the increase contributed by term premiums, while the risk-neutral rate has remained largely unchanged. Meanwhile, although forward inflation expectations have been generally low throughout July, they have shown signs of a slow rise, especially after the July FOMC meeting, where the pace of rising inflation expectations and repricing seems to be accelerating.
Specifically, we believe the accelerated rise in term premiums and the signs of rising inflation expectations during this phase are mainly due to the concentrated outbreak of fiscal concerns, supply-demand mismatch pressure, and policy uncertainty. The market does not appear to have fully priced in these risks yet.
First, on the fiscal side, deficit pressures continue to expand, systematically raising the center of long-duration supply in the medium-to-long term. In the first half, market discussions on fiscal deficits and tariff policies were overshadowed by geopolitical risks. However, with the recent progress of tariff refunds and the approach of the midterm elections, concerns about fiscal pressure have re-entered the market's view. On the revenue side, the concentrated payment of IEEPA tariff refunds is creating direct funding pressure on the fiscal side. As tariffs levied under the International Emergency Economic Powers Act (IEEPA) were ruled illegal by the courts, the government must refund a total of approximately $166 billion in tariff payments. Since the start of the refund process this fiscal year, the Treasury has completed $81 billion in refunds (mainly concentrated in May-June), with nearly half of the funds still awaiting payment. We estimate that the refunds will push up the deficit ratio by about 0.6 percentage points, significantly tightening the fiscal funding chain in the short term.
Alternative tariff provisions are unlikely to fully fill the tax revenue gap, making it difficult to alleviate the long-term pressure of fiscal bond issuance. Although the government has attempted to use Section 301 of the Trade Act of 1974 to replace Section 122 for policy transition, it is still difficult to make up for the massive tax revenue loss from the refunds. In the short term, the sharp decline in tariff revenue directly pushes up the fiscal deficit for the year. According to the Yale Budget Lab, new U.S. tariff revenue in fiscal 2026 could fall to about $80 billion, less than half of the fiscal 2025 figure ($190 billion). Considering the impact of the refunds, this means that the single factor of declining tariff revenue alone could push the fiscal 2026 deficit ratio an additional 0.3-0.4 percentage points higher than the fiscal 2025 figure (5.8%). In the long term, the coverage of new regulations is limited, and the structural gap will force duration supply to remain high. The tax revenue generated by the current Section 301 and 338 provisions can only cover less than 60% of the revenue from the previous reciprocal tariff phase. According to CRFB estimates, the IEEPA ruling will cumulatively lose about $1.7 trillion in tax revenue by fiscal 2036, while the new regulations are expected to generate only $950 billion, filling less than 60% of the gap. This long-term structural gap will force the Treasury to continue expanding the scale of bond issuance, driving long-duration Treasury supply to remain high.
On the expenditure side, the escalation of geopolitical conflicts is causing passive military spending expansion, adding rigid upward pressure to the fiscal deficit. This poses a severe challenge to the current administration's fiscal balance capabilities. The U.S. defense budget for fiscal 2026 is approximately $876.8 billion. As of June, the current fiscal year's spending has reached $678.7 billion (nearly 80%). If the U.S.-Iran conflict fails to de-escalate, the prolongation of geopolitical games will force a rigid expansion of defense spending and overseas military aid. This not only weakens the room for future fiscal stimulus but also directly translates into additional bond issuance, exacerbating the supply-demand imbalance for long-duration Treasuries.
Furthermore, with midterm elections approaching, the political urgency to alleviate the affordability burden on residents is becoming increasingly acute. To secure the support of low- and middle-income voters, drawing on previous policy ideas, the government may implement a package of measures such as setting a cap on credit card interest rates (e.g., a 10% cap proposal), issuing targeted livelihood and consumption subsidies, and using administrative and quasi-fiscal means to guide mortgage rates lower. These actions would directly ease the cost-of-living pressure on the household sector. Although there is a time lag from policy framework design to legal implementation, and the probability of these measures fully taking effect within the year is limited, their marginal impact on financial markets may appear in advance. The market's rekindled expectations of a second round of fiscal expansion and deficit growth could push up the supply premium on Treasuries and the expected inflation midpoint, thereby exerting sustained upward pressure on long-end Treasury yields.
Second, the supply-demand dynamics for duration have deteriorated to some extent, forcing term premiums higher. The current total size of U.S. government debt has exceeded the $39 trillion mark, with the debt-to-GDP ratio remaining at a historical high of 120%. However, while the Treasury continues to release a "flood" of bond supply, the marginal capacity on the demand side has shown clear weakening. First, the policy orientation of the new Fed Chair, Kevin Warsh, toward shrinking the balance sheet has strengthened expectations of medium-to-long-term liquidity tightening. Warsh's role signals that the Fed will adhere to monetary policy discipline and balance sheet constraints, making it difficult to return to the previous extreme accommodation of "flooding the market." This means the central bank's role as a backstop for long-end Treasuries is gradually weakening.
Second, the marginal withdrawal of core buyers, such as foreign official institutions, has further exacerbated the market's duration mismatch pressure. This year, the allocation momentum of foreign investors to Treasuries has slowed significantly. Notably, the Bank of Japan and domestic institutions, as the largest foreign holders of U.S. Treasuries, have been heavy sellers. In the first five months of this year alone, Japan cumulatively net sold up to $80 billion in Treasuries. The characteristics of supply-demand imbalance in the Treasury market are becoming increasingly prominent, forcing long-end Treasuries to raise term premiums to clear the excess duration supply and attract marginal private-sector buyers.
Third, the wave of AI capital expenditure is increasing the supply of investment-grade corporate bonds, creating a certain "crowding-out effect" on funds allocated to long-end Treasuries. This year, to raise massive capital expenditures for AI computing infrastructure, major cloud companies have significantly increased the issuance scale of high-grade corporate bonds. As of the second quarter of 2026, the quarterly capital expenditure of the five major cloud companies (including Microsoft, Google, Meta, Amazon, and Oracle) reached $180 billion (up about 90% year-over-year), with long-term debt reaching $700 billion (nearly double the beginning of 2025). The "substitution effect" of high-grade corporate bonds forces Treasuries to raise term premiums to maintain their attractiveness. This wave of high-quality, high-yield corporate bond supply directly crowds out institutional allocation funds (such as from insurance companies, pension funds, and asset managers) that were originally deposited in long-term Treasuries. With dealer and institutional balance sheet capacity already tight, Treasuries must offer higher yield compensation (i.e., higher term premiums) to compete in the "fund pool" against high-grade corporate bonds. This marginally further contributes to the upward slope of long-end Treasury yields.
Finally, Kevin Warsh's "vague framework" and "talk but no action" policy stance are systematically intensifying the market's repricing of long-term inflation risk. Especially after the July FOMC meeting, although Warsh strongly emphasized his hawkish determination to fight inflation, this policy divergence of "strong statements, lagging actions" has paradoxically increased the market's "policy trust deficit." The market is beginning to deeply worry that the Fed will be "behind the curve" in dealing with potential supply-side shocks and secondary inflation. This ambiguity in the policy path and the disconnect in execution are causing the medium-to-long-term inflation anchor to loosen, prompting investors to demand higher inflation risk premiums. After the press conference following the July FOMC meeting, short-end rates declined noticeably, but influenced by inflation expectations, long-end rates rose further to 4.7%.
Key Dimensions to Watch for a Break in the Treasury Market
In summary, we believe the steepening of the yield curve will constitute the core trading theme for the U.S. Treasury market in the second half of the year. Under the multiple pressures of fiscal deficit expansion forcing bond issuance, marginal duration reduction by foreign buyers, the "fund crowding-out effect" from the AI giant financing wave, and the risk of a rising long-term inflation midpoint, the pricing framework for Treasuries is undergoing a structural transformation. This also means that simply betting on accommodative policy expectations may not unilaterally suppress the high long-end rates; the dominance of long-end Treasuries is rapidly shifting toward term premiums and supply-demand fundamentals.
Looking ahead to the second half, the resolution and rebalancing of the Treasury market's trajectory will require close monitoring of the following core indicators:
1) Fundamentals and real rates (short-end anchor): If macroeconomic and inflation data can show a sustained trend of slowing, it could effectively lower short-term real rates and policy rate expectations. 2) Tariff offsets and fiscal gaps (fiscal and supply side): On the revenue side, whether the government will introduce new tariff measures in the second half (to supplement fiscal revenue with tariff income) to marginally alleviate the bond issuance pressure from refunds. On the expenditure side, observe the rigid expansion of defense spending triggered by geopolitical conflicts and the secondary squeeze on fiscal spending from livelihood subsidies for low- and middle-income voters (e.g., affordability measures). If rigid expansion on the expenditure side crowds out room for fiscal maneuver, it will directly force the bond issuance flood to remain high, worsening the supply-demand imbalance for duration. 3) Progress of foreign selling and the AI crowding-out effect (demand side): Focus on tracking the marginal duration-reduction trends of foreign official institutions, especially Japan. As pressure from the yen's depreciation eases, observe whether the Bank of Japan gradually slows its pace of Treasury sales, reducing upward pressure on term premiums. Also, monitor the "crowding-out effect" of long-duration, high-grade corporate bonds issued by tech giants (Hyperscalers) for AI computing infrastructure on funds allocated to Treasuries. 4) Progress on Kevin Warsh's reform task force (policy uncertainty expectations): Whether the reform working group established by the new Fed Chair Kevin Warsh (involving communication mechanisms, the balance sheet, and the inflation framework) can quickly deliver a concrete plan to fundamentally alleviate the Fed's deep dilemma of balancing "balance sheet discipline, liquidity management, and political independence," thereby repairing the market's term premium and inflation risk expectations.
This article is sourced from global macro analysis.
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