Guolian Minsheng Securities Company Limited has released a research report stating that the accelerated rise in US Treasury yields has become a focal point for global asset pricing this year, with the upward shift in the risk-free rate suppressing equity valuations and boosting volatility. In the first half of the year, markets primarily priced in monetary policy shifts driven by economic recovery and energy shocks, as short-term rates rose rapidly with rate hike expectations, producing a 鈥渂ear flattening鈥?yield curve.
However, since July, weakening fundamentals and the Fed鈥檚 hesitancy on rate hikes have slowed short-term momentum, while long-term rates have surged higher on the back of term premiums, with curve steepening intensifying. The report argues that US Treasury pricing is shifting from a single policy rate dominance to a multi-dimensional framework of 鈥渇iscal risk premium + supply-demand mismatch + policy uncertainty and long-term inflation risk.鈥?In the second half, long-term rates are likely to remain elevated, and curve steepening may become a core theme, requiring close monitoring of variables such as fundamental data, the fiscal gap and tariff offsets, foreign selling, the crowding-out effect from AI corporate bonds, and progress on the Warsh reform.
What Has Driven the US Treasury Market in the First Half?
The rising US Treasury yields since the start of the year can be understood through a classic decomposition framework, where the nominal yield on 10-year Treasuries splits into expected short-term real rates, forward inflation expectations, and term premiums (including real and inflation risk premiums). Expected short-term real rates reflect market consensus on the Fed鈥檚 near-term monetary policy path and the long-run equilibrium real rate, directly tied to economic fundamentals and the pace of policy shifts. Forward inflation expectations price the market鈥檚 view on medium- to long-term price stability and the Fed鈥檚 inflation anchoring credibility. Term premiums compensate investors for the uncertainty of holding long-term bonds, such as interest rate and inflation uncertainty, supply-demand imbalances, and fiscal issuance pressures.
In the first half of the year, the core driver of US Treasury yields came from expected short-term real rates. According to the DKW model (with minor variations across models, but similar trends), from January to June, the 10-year yield rose 23 basis points, of which expected short-term real rates contributed about 15 basis points, or roughly 65% of the nominal increase. Forward inflation expectations and term premiums each rose only about 4 basis points, contributing a combined 35%.
Specifically, after the Iran conflict, the drivers of US Treasury yields shifted in distinct phases. In the first phase, from the outbreak of the Iran conflict to mid-May, all three factors rose together. The escalation of Middle East tensions pushed up commodity prices, intertwining geopolitical uncertainty with supply-side inflation risks, causing inflation expectations and term premiums to spike. Meanwhile, strong US economic data further reduced rate cut expectations, lifting expected short-term real rates, and together they drove the 10-year yield higher. In the second phase, from mid-May to the end of June, as geopolitical risks eased and oil prices fell, the earlier inflation expectations and term premiums were quickly reversed, returning to pre-conflict levels by end-June. However, supported by the Fed鈥檚 鈥渉igher for longer鈥?stance and expectations of a no-landing economy, expected short-term real rates remained elevated, forming the core underpinning for the rise in the yield curve鈥檚 midpoint.
In summary, the first half of the US Treasury market was more of a fundamental-driven 鈥減olicy rate repricing鈥?episode, where markets focused on repricing around the 鈥渆conomic resilience鈥?rate cut delay鈥?narrative, a classic fundamental-driven logic. During this period, inflation expectations were volatile due to geopolitical factors but remained anchored overall, and supply-demand imbalances and term premium compression were not yet dominant. The yield curve primarily exhibited a 鈥渂ear flattening鈥?pattern, with short-term rates rising to catch up with long-term rates.
What Are the Core Contradictions in the US Treasury Market in the Second Half?
Since July, the logic driving US Treasury yields has shifted, as reflected in the bear steepening of the yield curve: term premiums have taken over from expected short-term real rates as the main driver pushing long-term yields higher. First, the slowing economy and the Fed鈥檚 hesitation on rate hikes have diminished the momentum of expected short-term real rates. As macroeconomic indicators like non-farm payrolls, inflation, and GDP show signs of marginal weakening, and with the Fed cautious on the policy rate path, the momentum for further upward revisions in rate hike expectations has weakened. Since July, the pull effect of expected short-term real rates on long-term yields has diminished significantly, with overall momentum slowing. However, long-term nominal rates have risen sharply on the back of term premiums, accelerating the bear steepening of the yield curve. Since July, the 10-year yield has risen about 30 basis points, almost entirely driven by term premiums, while risk-neutral rates have remained largely unchanged. Meanwhile, forward inflation expectations, though generally low, have shown a gradual upward trend, especially after the July FOMC meeting, where inflation expectations and repricing appeared to accelerate.
We believe the acceleration in term premiums and the uptick in inflation expectations during this period mainly stem from fiscal concerns, supply-demand mismatch pressures, and a concentrated outbreak of policy uncertainty, which the market may not have fully priced in. On the fiscal side, the deficit pressure continues to expand, systematically raising the supply of long-duration debt. In the first half, discussions about the fiscal deficit and tariff policies were overshadowed by geopolitical risks, but with the recent progress of tariff refunds and the approaching midterm elections, concerns about fiscal pressure have resurfaced. On the revenue side, the refund of tariffs levied under the IEEPA is creating direct fiscal pressure. The government must refund approximately $166 billion in tariffs after the IEEPA-based tariffs were ruled illegal. Since the start of the refund process in this fiscal year, the Treasury has completed $81 billion in refunds (mainly in May-June), with nearly half still pending. 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 revenue gap, and the medium- to long-term pressure on bond issuance is hard to resolve. In the short term, the sharp drop in tariff revenue directly boosts the deficit for the year. According to estimates from the Yale Budget Lab, US tariff revenue in fiscal 2026 could fall to about $80 billion, less than half of fiscal 2025鈥檚 $190 billion. Considering the impact of refunds, this means the decline in tariff revenue alone could push the fiscal 2026 deficit ratio up by 0.3-0.4 percentage points from fiscal 2025鈥檚 5.8%. In the long term, the coverage of new regulations is limited, and structural gaps will keep long-duration supply high. The revenue from the current Section 301 and 338 tariffs can only cover less than 60% of the revenue from the previous reciprocal tariff phase. According to CRFB estimates, the IEEPA ruling will result in a cumulative loss of 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 bond issuance, keeping long-term supply high. On the spending side, rising geopolitical conflicts are driving passive military spending expansion, adding rigid pressure on the fiscal deficit. This poses a serious challenge to the Trump administration鈥檚 fiscal balance. The US defense budget for fiscal 2026 is about $876.8 billion, with $678.7 billion already used (nearly 80%) by June. If the US-Iran conflict does not cool down, the long-term nature of geopolitical games will force rigid expansion in defense spending and overseas military aid, not only reducing room for fiscal stimulus but also directly translating into additional bond issuance, exacerbating the supply-demand imbalance in long-duration debt. Furthermore, with midterm elections approaching, the Trump administration鈥檚 political urgency to relieve household affordability is growing. To win over the low- and middle-income voter base, the administration may use a combination of measures, such as setting a cap on credit card interest rates (e.g., a 10% cap proposal), issuing targeted subsidies for livelihoods and consumption, and using administrative and quasi-fiscal means to guide mortgage rates lower, to directly ease the cost of living pressures on households. Although there is a time lag from policy framework planning to legal implementation, making it unlikely for these measures to take full effect within the year, their marginal impact on financial markets could appear earlier: renewed market expectations of a second round of fiscal expansion and deficit expansion could push up the supply premium and inflation expectations for US Treasuries, exerting sustained upward pressure on long-term yields.
Second, the supply-demand dynamics for long-duration debt have deteriorated to some extent, forcing term premiums higher. The total size of US Treasury debt has surpassed $39 trillion, with the debt-to-GDP ratio remaining at a historical high of 120%. However, while the Treasury continues to release a 鈥渟upply flood鈥?of bonds, the marginal demand on the side is weakening. First, the policy orientation of shrink the Fed鈥檚 balance sheet, under the Warsh leadership, has strengthened expectations of medium- to long-term liquidity tightening. The handover to Warsh sends a clear signal that the Fed will adhere to monetary policy discipline and balance sheet constraints, making it unlikely to return to the ultra-loose 鈥渇lood of liquidity鈥?approach, meaning the central bank鈥檚 role as a backstop for long-term Treasury bonds is gradually weakening. Second, the marginal withdrawal of core buyers, such as foreign official institutions, has further exacerbated the market鈥檚 duration mismatch. This year, foreign allocation to US Treasuries has slowed noticeably, with the Bank of Japan and domestic institutions, the largest foreign holders, selling heavily: from January to May alone, Japan net sold US Treasuries totaling $80 billion. The imbalance in the US Treasury market has become increasingly prominent, forcing long-term bonds to raise term premiums to clear excess duration supply and attract marginal private sector buyers. Third, the AI capital expenditure boom has increased the supply of investment-grade corporate bonds, creating a certain 鈥渃rowding-out effect鈥?on funds allocated to long-term Treasury bonds. This year, to raise vast capital expenditures for AI computing infrastructure, major cloud providers have significantly increased their issuance of high-grade corporate bonds. As of Q2 2026, the five major cloud providers (including Microsoft, Google, Meta, Amazon, and Oracle) had quarterly capital expenditures of $180 billion (up about 90% year-over-year), with long-term debt of $700 billion (nearly double from the start of 2025). The 鈥渟ubstitution effect鈥?of high-grade corporate bonds forces US Treasuries to raise term premiums to maintain attractiveness. This wave of high-quality, high-yield corporate bond supply directly crowds out the institutional funds (such as insurance, pension funds, and asset managers) that would otherwise be allocated to long-term government bonds. With dealer and institutional balance sheet capacity already tight, Treasuries must offer higher yield compensation (i.e., higher term premiums) to compete for the pool of funds, further contributing to the upward slope of long-term yields.
Finally, the 鈥渇uzzy framework鈥?and 鈥渢alk but no action鈥?policy stance of the new Fed chair, Warsh, are systematically exacerbating the market鈥檚 re-pricing of long-term inflation risk. Especially after the July FOMC meeting, although Warsh strongly emphasized his hawkish anti-inflation stance, the disconnect between 鈥渢ough talk, lagging action鈥?has increased the market鈥檚 trust deficit in policy. The market is now deeply concerned that the Fed may 鈥渇all behind the curve鈥?in responding to potential supply-side shocks and secondary inflation. This ambiguity in policy direction and the gap in execution are causing medium- to long-term inflation anchoring to loosen, prompting investors to demand higher inflation risk premiums. After the July FOMC press conference, short-term rates fell notably, but under the influence of inflation expectations, long-term rates rose further to 4.7%.
Key Dimensions to Watch for a Break in the US Treasury Market
In summary, we believe that yield curve steepening will be the core trading theme for the US Treasury market in the second half. Under multiple pressures, including fiscal deficit expansion forcing bond issuance, foreign buyers reducing duration, the AI giant financing wave creating a 鈥渃rowding-out effect,鈥?and the risk of a rising long-term inflation midpoint, the US Treasury pricing framework is undergoing a structural transformation. This also means that relying solely on easing expectations may not be able to unilaterally suppress elevated long-term rates; the dominance of long-term Treasury yields is rapidly shifting toward term premiums and supply-demand fundamentals. Looking ahead to the second half, the break and rebalancing of US Treasury trends will require close tracking of the following core indicators: 1) Fundamentals and real rates (short-term anchor): If macroeconomic and inflation data show a sustained slowdown trend, it could effectively lower short-term real rates and policy rate expectations. 2) Tariff offsets and fiscal gap (fiscal and supply side): On the revenue side, whether the Trump administration will introduce new tariff measures in the second half to supplement the fiscal revenue gap and marginally ease the pressure from refunds; on the spending side, observe the rigid expansion of defense spending due to rising geopolitical conflicts and the secondary squeeze on fiscal spending from subsidies for low- and middle-income voters (e.g., affordability measures). If rigid spending expansion squeezes fiscal space, it will directly push bond issuance highs to remain elevated, exacerbating the duration supply-demand imbalance. 3) Progress of foreign selling and AI crowding-out effect (demand side): Key focus on the marginal duration-reducing moves of foreign official institutions, particularly Japan. As the yen depreciation pressure eases, observe whether the Bank of Japan gradually slows its pace of selling US Treasuries, reducing the upward pressure on term premiums; also monitor the 鈥渃rowding-out effect鈥?of long-duration, high-grade corporate bonds issued by tech giants (Hyperscalers) for AI computing infrastructure on Treasury allocation funds. 4) Progress of the Warsh reform group (policy uncertainty expectations): Whether the reform working group established by the new Fed chair Warsh (involving communication mechanisms, the balance sheet, and the inflation framework) can quickly produce a concrete plan, thereby alleviating the Fed鈥檚 deep dilemma in balancing 鈥渟hrinkage discipline, liquidity management, and political independence鈥?from an institutional perspective, and repairing the market鈥檚 term premiums and inflation risk expectations. Risk warnings: AI demand significantly slows; US inflation persistence exceeds expectations; geopolitical conflicts escalate and oil prices rise sharply; US fiscal policy exceeds expectations.
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