Guolian Minsheng Securities: What are U.S. Treasuries pricing in?

Guolian Minsheng Securities released a research report stating that since the beginning of this year, the accelerated rise of U.S. Treasury yields has become the focus of global asset pricing. The increase in risk-free interest rates has suppressed equity valuations and raised volatility. In the first half of the year, the market primarily priced in the monetary policy shift due to economic recovery and energy shocks, with short-term rates soaring rapidly alongside rising interest rate expectations, resulting in a bear flattening of the yield curve. However, after July, weakening fundamentals and hesitation from the Federal Reserve regarding rate hikes slowed the momentum of short-term yields, while long-term rates accelerated due to the pull of term premium, further steepening the curve. The firm believes that the pricing of U.S. Treasuries is shifting from a single policy rate-driven focus towards a multidimensional framework resonating with fiscal risk premium + supply-demand mismatch + policy uncertainty and long-term inflation risk. In the second half of the year, long-term rates are likely to rise while being difficult to lower, and the steepening of the curve may become a central theme, necessitating close monitoring of variables such as fundamental data, fiscal gaps and tariff offsets, foreign capital reduction, the crowding-out effect on AI corporate bonds, and the progress of Wash reform. The original text is as follows: Since the beginning of this year, the accelerated rise of U.S. Treasury yields has again become the focus of global asset pricing. Alongside the rapid increase in Treasury yields, the global financial asset pricing anchor of risk-free interest rates has quickly moved up, directly suppressing equity valuations and triggering profound adjustments in cross-asset allocation. In this process, the negative correlation between U.S. stocks and Treasuries has re-emerged after being temporarily broken, and the volatility of global financial markets has also been pushed to high levels. However, beneath the rapid rise in Treasury yields, the core factors driving this round of increases seem to be changing. In the first half of the year (up to the end of June), the market mainly priced in the monetary policy shift resulting from economic recovery and energy shocks: the Federal Reserve's policy expectations rapidly reversed from pricing in 1-2 rate cuts throughout the year at the beginning of the year to expectations of rate hikes. Short-term rates followed suit and surged, converging towards long-term rates, leading the yield curve to exhibit a typical bear flattening shape. But entering July, due to weakening fundamentals and hesitation from the Federal Reserve regarding rate hikes, the upward momentum of short-term yields began to slow. In contrast, long-term rates accelerated. The trend of yield curve steepening continued to strengthen, with term premiums taking the lead as the core driver of rising long-term yields. We believe that this shift may indicate that the pricing framework of the Treasury market is moving away from a single policy rate expectation model, transitioning to a multidimensional pricing system driven by fiscal risk premium + concerns about supply-demand mismatch + policy uncertainty and long-term inflation risk. Against this backdrop, in the second half of the year, it may become increasingly difficult to lower long-term rates while they are easy to raise, with yield curve steepening becoming a core theme that runs through the market. 1. What is the U.S. Treasury market pricing in the first half of the year? How to understand the DRIVES behind the rise of U.S. Treasury yields since the beginning of the year? Using a classic interest rate decomposition framework, nominal U.S. Treasury yields can be split into expected short-term real interest rates, forward inflation expectations, and term premiums (actual term premiums + inflation risk premiums). Among them, 1) Expected short-term real interest rates reflect the market's consensus forecast of the Federal Reserve's monetary policy path in the medium to short term and the long-term equilibrium real interest rate. This is directly linked to the underlying growth momentum of the economy (such as labor productivity and capital returns) as well as the pace of the Federal Reserve's policy shift; 2) Forward inflation expectations represent the financial markets pricing of medium to long-term price stability and the Federal Reserve's ability to anchor inflation; 3) Term premiums are the extra risk compensation that investors demand for bearing the uncertainty risks associated with holding long-term bonds (such as interest rate and inflation uncertainty risks, supply-demand imbalance risks, and fiscal issuance pressures). It is not difficult to see that the core driving factors of U.S. Treasury yields in the first half of the year primarily stem from expected short-term real interest rates. According to the DKW model's decomposition of U.S. Treasury yields (estimates may vary slightly among different models, but overall trends are similar, such as the commonly used ACM model), in the first half of the year (up to June), the 10-year Treasury yield rose 23 basis points, with expected short-term real interest rates contributing approximately 15 basis points, accounting for about 65% of the nominal yield increase, while forward inflation expectations and term premiums only increased by about 4 basis points each, together contributing just 35%. Specifically, after the Iran conflict, the driving factors of U.S. Treasuries showed a clear phase-switching characteristic: The first stage (Geopolitical conflict escalation period: from the outbreak of the Iran conflict to mid-May): A resonance of three major factors lifting yields. The sudden escalation of the Middle East situation drove prices of commodities like oil higher, intertwining geopolitical uncertainty and supply-side inflation risks, resulting in a short-term surge in inflation expectations and term premiums. At the same time, strong economic data from the U.S. further reduced market rate cut expectations, with expected short-term real interest rates rising in tandem, driving the 10-year Treasury yield to quickly ascend. The second stage (Geopolitical risk calming period: from mid-May to the end of June): A retreat of inflation and term premiums, with real interest rates sustaining high levels. As the Iran situation marginally eased and oil prices significantly fell, previously factored-in inflation expectations and term premiums were quickly erased, returning to levels prior to the outbreak of the conflict by the end of June. However, supported by the Federal Reserve's Higher for Longer hawkish stance and expectations of a soft landing for the economy, expected short-term real interest rates remained high, becoming the core underpinning of the mid-year rise in Treasury yields. In conclusion, the U.S. Treasury market in the first half of the year was more about a "policy rate repricing" driven by fundamentals, where the market was mainly focused on the economic resilience - delayed rate cuts policy rate repricing, following a typical fundamentals-driven logic. During this stage, although inflation expectations were occasionally influenced by geopolitical factors, they were generally well-anchored, and supply-demand imbalances did not yet dominate term premiums. The yield curve primarily manifested as a bear flattening shape with short-term rates catching up to long-term rates. 2. What are the core conflicts in the U.S. Treasury market for the second half of the year? As we entered July, the upward logic of U.S. Treasury yields underwent a certain shift, particularly manifested in the bear steepening of the yield curveterm premiums took over from expected short-term real interest rates and became the core driver of rising long-term Treasury yields. Firstly, the slowdown in fundamentals and hesitation from the Federal Reserve regarding rate hikes led to diminished momentum for expected short-term real interest rates. As macroeconomic indicators such as non-farm payrolls, inflation, and GDP showed signs of marginal weakness, coupled with the Federal Reserve's caution and hesitation regarding the path of policy rates, market momentum for further rate hike expectations weakened. Since July, the impact of expected short-term real interest rates on long-term yields has significantly reduced, resulting in a generalized slowdown in upward momentum. However, long-term nominal rates have been rising sharply on the back of term premiums, causing the yield curve to steepen rapidly. Observably, since July, the 10-year Treasury yield has risen by about 30 basis points, almost entirely from contributions by term premiums, while the risk-neutral rate has remained basically unchanged. Meanwhile, throughout July, although forward inflation expectations have generally remained at low levels, they have shown signs of a slow upward trend, particularly after the FOMC meeting at the end of July, where inflation expectations appeared to accelerate. Specifically, we believe that the acceleration of rising term premiums and signs of rising inflation expectations during this phase are primarily driven by the concentrated emergence of fiscal concerns, supply-demand mismatches, and policy uncertainties, and the market currently seems to have not fully priced in these risks: Firstly, on the fiscal side, deficit pressures continue to expand, systematically raising the duration supply center in the medium to long term. In the first half of the year, discussions in the market around fiscal deficits and tariff policies were momentarily overshadowed by geopolitical risks, but with recent developments in refund processes and the approach of mid-term elections, concerns about fiscal pressures have returned to the market's view. In terms of income, the concentrated repayments of tariffs related to the International Emergency Economic Powers Act (IEEPA) create direct financial pressures on the fiscal side. Since a judicial ruling deemed relevant tariffs imposed earlier based on IEEPA to be illegal, the government is required to refund approximately $166 billion in tariffs. Since the commencement of refunds in the current fiscal year, the Treasury Department has completed $81 billion in refunds (mainly between May and June), with nearly half of the funds still pending. We estimate that the refunds are expected to push the deficit rate up by about 0.6 percentage points, significantly tightening the fiscal cash flow chain in the short term. Moreover, replacement tariffs are unlikely to fully make up for the tax revenue shortfall, complicating long-term fiscal borrowing pressures. Although the government is attempting to use the Trade Act of 1974's Section 301 to transition policies instead of Section 122, it still struggles to compensate for the massive tax losses caused by refunds: In the short term, the significant shrinkage of tariff revenue directly raises the deficit for the year. According to forecasts from the Yale Budget Lab, new tariff revenues in the 2026 fiscal year may drop to around $80 billion, less than half of the 2025 fiscal year's $190 billion level. Considering the impact of refunds, this means that the decline in tariff revenue alone will lead to an additional increase in the deficit rate for the 2026 fiscal year compared to the 2025 fiscal year (5.8%) of 0.3 to 0.4 percentage points. In the long term, new regulations will have limited tax coverage, forcing structural gaps that will maintain high duration supplies. The current provisions under Sections 301 and 338 can only generate tax revenues equivalent to less than 60% of the previous counterpart tariffs. According to CRFB estimates, by the 2036 fiscal year, the IEEPA ruling will cumulatively lead to a loss of about $1.7 trillion in tax revenues, while the new regulations are expected to generate only $950 billion, filling less than 60% of the gap. This long-term structural gap will compel the Treasury to continuously expand Treasury issuance, driving high-duration supplies of long-term U.S. Treasuries. On the expenditure side, escalating geopolitical conflicts are leading to passive expansions in military spending, which constitutes an additional rigid pressure on fiscal deficits. This poses a severe test for the Trump administration's fiscal balance capability. The defense budget for the 2026 fiscal year is about $876.8 billion, and as of June, nearly 80% of the current fiscal year's budget has already been spent ($678.7 billion). If subsequent U.S.-Iran conflicts do not cool down in a timely manner, the prolonged nature of geopolitical competition will force rigid expansions in defense spending and overseas military aid budgets, which not only diminishes the fiscal space for future stimuli but will also directly additional increments in Treasury issuances, exacerbating the supply-demand imbalance in long-term Treasuries. In addition, as midterm elections approach, the Trump administration faces increasing urgency in alleviating political demands for residents' affordability. To capture the support of low- to middle-income voters, referencing last year's policy approach could lead them to set credit card interest rate caps (such as a proposal for a 10% limit), distribute targeted subsidies for living and consumption, and use administrative and quasi-fiscal measures to guide down housing loan interest rates, directly easing the living cost pressures for households. Although there remain time lags between policy framework planning and legislative implementation, it is unlikely that related measures will come into full effect within this year. However, the marginal impacts on financial markets could appear in advance: the renewed market expectations for secondary fiscal expansion and deficit growth may push up the supply premium for Treasuries as well as inflation expectations, thus exerting continuous upward pressure on long-term Treasury yields. Secondly, the duration supply-demand pattern has worsened to a certain extent, which is driving term premiums higher. Currently, the total size of U.S. Treasuries has surpassed $39 trillion, with the ratio of Treasuries to GDP maintaining at a historical high of 120%. However, as the Treasury Department continues to release a supply torrent of Treasuries, the marginal capacity on the demand side has significantly weakened. One, the policy orientation of the Wash tapering has strengthened expectations for tightening liquidity over the medium to long term. Washs succession has sent a clear signalthe Federal Reserve will adhere to monetary policy discipline and balance sheet constraints, making it difficult to return to the previous state of extreme easing characterized by flooding the market, which means the central bank's function as a backstop for long-term Treasuries is gradually weakening. Two, the marginal exit of core buyers such as overseas official institutions has further exacerbated the duration mismatch pressure in the market. This year, foreign investment in U.S. Treasuries has notably slowed, with significant selling from the Bank of Japan and domestic institutions, which are the largest overseas holders of U.S. TreasuriesJapan alone has net sold a staggering $80 billion in U.S. Treasuries between January and May of this year. The characteristics of supply-demand imbalance in the Treasury market are becoming increasingly pronounced, forcing long-term Treasuries to heighten term premiums to clear excess duration supply and attract marginal buyers from the private sector. Three, the surge in capital expenditures for AI is increasing the supply of investment-grade corporate bonds, which creates a certain crowding-out effect on the allocation of funds for long-term Treasuries. This year, major cloud vendors have significantly ramped up the issuance of high-rated corporate bonds to raise huge capital for AI computing infrastructure. As of Q2 2026, the five major cloud providers (including Microsoft, Google, META, Amazon, and Oracle) had capital expenditures reaching $180 billion for the quarter (about a 90% year-on-year increase), with long-term debt hitting $700 billion (almost doubling compared to early 2025). The substitution effect of high-rated corporate bonds forces long-term 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 that were originally settled in long-term Treasuries (such as insurance, pension funds, and asset management institutions). Under the background of tightening market makers and institutional balance sheets, Treasuries must provide higher yields (i.e., higher term premiums) to clear the competition for the funding pool against high-rated corporate bonds, further marginally skewing upward long-term Treasury yields. Finally, the ambiguous framework and talk without action policy statements from Wash are systematically exacerbating the market's re-pricing of long-term inflation risks. Especially after the July FOMC meeting, although Wash stressed his hawkish determination against inflation, this strong rhetoric with delayed action policy divergence has conversely intensified the financial market's deficit in policy trust. The market is beginning to deeply worry that the Federal Reserve is behind the curve in responding to potential supply-side shocks and secondary inflation. This ambiguity in policy paths and disconnection from execution increases the risk of loosening long-term inflation anchoring, thereby prompting investors to demand higher inflation risk premiums. After the press conference following the July meeting, short-term rates noticeably declined, but under the influence of inflation expectations, long-term rates rose further to 4.7%. 3. Key dimensions to closely monitor for breaking the impasse in the U.S. Treasury market In summary, we believe that the steepening of the yield curve will constitute the central trading line of the U.S. Treasury market in the second half of the year. Under multiple pressures such as fiscal deficit expansion forcing issuance pressures, marginal duration reductions by overseas buyers, the financing frenzy of AI giants creating a "crowding-out effect," and the facing risk of rising long-term inflation expectations, the pricing framework of U.S. Treasuries is undergoing structural reconstruction. This also means that solely relying on easing expectations may not unidirectionally suppress high long-term rates, as the dominance in long-term Treasuries is accelerating towards term premiums and supply-demand fundamentals. Looking ahead to the second half of the year, the breakthrough and rebalancing of Treasury dynamics need to closely monitor the following core indicators: 1) Fundamentals and real interest rates (short-term anchor): Whether macroeconomic and inflation data can show a persistent slowdown trend, which would effectively lower short-term real interest rates and policy rate expectations; 2) Tariff offsets and fiscal gaps (fiscal and supply side): On the income side, whether the Trump administration will introduce new tariff measures in the second half of the year (to supplement fiscal gaps with tariff revenue) to marginally alleviate the issuance pressures brought by refunds; on the expenditure side, monitor the rigid expansion of defense military spending triggered by escalating geopolitical conflicts, as well as the secondary squeezing of fiscal expenditures from living subsidies for low- and middle-income voters (such as affordability measures). If the rigid expansion on the expenditure side occupies fiscal flexibility, it will directly force Treasury issuance peaks to remain high, exacerbating duration supply-demand imbalances; 3) Progress in foreign capital reduction and the AI crowding-out effect (demand side): Focus on the marginal duration trends of overseas official institutions, represented by Japan. As the pressure on the yen depreciates, observe whether the Bank of Japan gradually slows down the pace of U.S. Treasury reduction, alleviating the upward pressure on term premiums; at the same time, observe the crowding-out effect on Treasury allocation funds from long-term, high-rated corporate bonds issued by tech giants (Hyperscalers) for AI computing infrastructure. 4) Progress in the implementation of the Wash reform group (policy uncertainty expectations): Whether the reform working group set up by the Federal Reserve's new chairman Wash (involving communication mechanisms, balance sheet and inflation framework, etc.) can quickly produce landing plans to alleviate the deep dilemmas faced by the Federal Reserve in balancing tapering discipline, liquidity management, and political independence at the institutional level, restoring market expectations for term premiums and inflation risks. Risk warnings: AI demand slows significantly; U.S. inflation proves stickier than expected; escalation of geopolitical conflicts and significant rises in oil prices; U.S. fiscal policies exceed expectations.