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  The View

The week that will be

  Markets currently revolve around the White House; tariffs & geopolitical headlines to remain in focus in the week ahead amidst elevated uncertainty (Exhibit 4). In North America, our economists expect tariff uncertainty will hold until a new USMCA is settled (see: Rationality (almost) always triumphs). Until then, the tariff threat will loom & risk further rate divergence (Exhibit 5). Europe may soon be in tariff cross hairs. Geopolitical chatter suggests keeping an ear out for Ukraine / Russia developments.

For markets, we see three broad takeaways: (1) the US administration is transactional, nothing is settled until it is final, (2) US economic policy threats must be taken seriously & literally, (3) US policy "put" may be deeper out of the money than the market expects. Investors have suggested the equity market is the US administration's scorecard and any policy changes that hurt risk assets will be quickly dialed back. We advise caution.

Upcoming events matter but White House is still market center of gravity. We will watch:

US: Payrolls today; BofA econ is above BBG (see: NFP preview). U Mich 5-10Y inflation expectations today also matter because they shape Fed tariff reaction flexibility.  US CPI is on Wednesday & retail sales next Friday where tariff & weather impact will be watched.  Our economists still see the Fed on hold this year and next, market sees downside risks brewing.

EU: ECB staff are expected to publish an update of their neutral rate. The 2pct flagged by ECB speakers seems optimistic to us; we see neutral closer to 1pct vs 2pct. Next big EU event is German election on Feb 23; we discuss pricing in scenarios in Rates EU.

UK: GDP will guide extent of BoE cuts. We expect stagnant economy in Q4 (0.0%), with risks of mild contraction. Dec GDP & services to rise 0.1%m/m, IP to fall by 0.2%m/m.

The week that was

     Most rate markets ex Japan saw yields decline with renewed concern over tariff-driven growth risks. Curve shapes diverged with the US curve bull flattening (Fed on hold & waiting for further data + growth risks building out the curve) but more parallel shifts in GE, UK, & Canada. BoE's 7-2 vote split surprised the market, but we read it differently: we pay March MPC-dated Sonia (Rates - UK). US data was mixed but the market focused on softer than expected JOLTS & ISM services. Regulatory optimism was re-kindled by dealer-friendly comments from Fed Governor Bowman.

  Rates - US

•  Tariffs pose downside growth risk & justify our soft long duration bias
• Fed hold + downside growth risks justify flatter front end, we like M5/Z6

Trade duties, honor, country

The US rates curve substantially flattened in the past week driven by tariff & nascent US growth concerns. US tariffs were imposed on China (10%) & larger tariffs (25%) on Canada & Mexico were temporarily avoided with enhanced border enforcement. The market over-weighted soft ISM services & JOLTS data, though broader data was mixed. All eyes will be on US NFP today; BofA econ is above consensus (see: NFP preview).

Our core rate views: duration = retain soft long bias in belly nominal & real rates; curve = belly outperformance vs wings via new M5Z6 flattener & 5s30s steepener; spreads = constructive front end wideners; vol = sticky high upper left vol with elevated macro uncertainty. For the remainder of US macro we discuss: tariffs, Feb refunding, the utility of directionality indicators, and impact of potential reg changes on swap spreads.

Tariff twists & turns: rates implications

Our stance on the impacts of tariffs has broadly been to learn from the Trump 1.0 playbook: pro-growth optimism transitioned into growth concerns on trade wars which then transitioned into a cutting Fed and lower rates. We continue to expect the post-election range of 4.2-4.8% to hold and continue to recommend adding duration towards upper end of that range (mix of nominal and real yields to hedge potential stagflation risks). Price moves this week hinted that growth will likely matter more than ST inflation.

The tariff impact on rates will come down to the Fed reaction function. Key to their reaction function will be inflation expectations. If inflation expectations rise with tariff-driven inflation, the Fed will likely turn hawkish. If inflation expectations are stable with tariff inflation, the Fed will have more flexibility to look through inflation & focus on downside growth risks. Ultimately, the Fed response function will depend on the severity of the risks, their sequencing over time, and how they project risks into the future.

The Fed may stay on hold all year (our house call) and watch patiently as inflation is already running a bit hot vs target and growth is unlikely to be impacted very quickly. The Fed may also act sooner, however, in either direction, with hikes to reduce inflation risk or cuts to reduce risk to jobs. A 2018 tariff assessment by the Fed showed them weighing the pros and cons of hikes and cuts, and at the time they appeared to lean more dovish, thinking that CPI impacts would be temporary and not massive in size.

The Fed near term is likely on hold as they wait for more data. The belly can outperform as the Fed path is adjusted downward 2 to 3 years ahead with higher growth concerns. To position we like M5/Z6 flatteners (see: Liquid Insight, Exhibit 6). Risk is stronger activity & inflation data that causes market to price out cuts and potentially price in hikes in future.

Feb refunding: "several quarters" stays for now

The February refunding was very close to our expectations (see our note: Feb refunding).

The refunding statement retained forward guidance language that UST "anticipates maintaining nominal coupon and FRN auction sizes for at least the next several quarters". This language was kept despite the TBAC report to UST Secretary that "uniformly encouraged Treasury to consider removing or modifying the forward guidance". Given TBAC's suggestion, we see elevated likelihood this language is modified or removed at the May refunding, consistent with an uncertain borrowing outlook.

Refunding communications make us comfortable with our baseline expectation for the next nominal auction size increases in Nov '25, though this could slip into '26. We expect auction size growth will be proportional to existing auction sizes & WAM stable.

Treasury's cash balance (TGA) received little attention at this refunding. In the financing estimates released Monday, Treasury assumed a stable TGA of $850b at end March & June, conditional on debt limit resolution. There was no mention of potentially targeting a lower TGA in the quarters ahead. A TGA shift is possible with new Treasury leadership (as we discussed in UST TGA: risk of lower cash balance). However, prudent liquidity risk management considerations are likely to limit the extent of any potential TGA changes.

Gauges of expansion likelihoods prices across assets

In The utility of directionality indicators from 5 Feb '25, we expand on a framework to estimate the likelihoods of expansion scenarios that are reflected in the dynamic of different assets. We apply this framework to 10y BEs and the relative dynamic of EM Corp credit spreads, IG Cash & IG/HY CDX vs. 10yT.

We favor fading c.80-85% expansion likelihoods expressed in the 10y BEs dynamic tactically (see Exhibit 27). Expansion likelihoods reflected in the EM Corp credit & IG Cash have faded recently to neutral levels, likely reflecting the recent headwinds to spread products and risk from a pickup of political and policy uncertainty (see Special topic).

Turning neutral on long-end spreads from tightener camp

This week's speech by Fed Gov Michelle Bowman tilted risk/reward towards near term spread widening. Longer term, we remain skeptical that regs changes will substantially increase demand for long-end USTs but we cannot fight the de-regs headlines which may pick up again when current Vice Chair Barr steps down at the end of the month. Fiscal deficit worries could later in the year drive a renewed cheapening trend for USTs, ie. tighter spreads. The near-term action is centered on de-regulation which could include reductions to leverage ratios and the GSIB surcharge. This could increase dealer capacity to provide repo and to hold USTs on their balance sheets. As a result, we move from a tightening bias to a neutral bias leaning. Spread widening could continue if de-reg momentum continues to build in direction of increased dealer capacity.

Bottom line: We expect the Fed to remain on hold but tariffs pose downside risks to growth. We like M5/Z6 flatteners because of potential for the belly to outperform as the Fed path is adjusted downward 2-3yrs ahead with higher growth concerns. We turn neutral on long-end spreads due to current de-regulatory momentum.

  Rates - EU

• 10y Bunds include a 10-15bp discount on expectations of more supply
• A rapid and meaningful debt brake change could imply c 35-40bp of upside to our forecast

There are three channels through which expectations of German fiscal change could affect Euro rates following the German elections:

1. A cheapening of German bonds vs swaps on expectation of more supply.
2. An increase in Euro rates as a result of more optimism around the medium to long-term outlook for German and thereby Euro Area growth
3. An increase in Euro rates as a result of a revised outlook for Euro Area fiscal stance as a whole, taking the change in Germany as a precursor to more spending at Euro Area level too.

Our conversations with clients suggest that the scenario of some change in the fiscal rule is consensus. This is something that is also apparent in our latest two FX and Rates Sentiment Surveys. Below, we discuss the extent to which markets may be pricing the above and the potential price action in the two tail scenarios of (a) an immediate removal of the debt brake in favour of long term capex investments, and (b) a clear blocking minority against a reform of the debt break.

Supply impact appear partially priced

We believe 10y Bunds could already be incorporating a c.10-15bp discount due to expectations of more German bond supply. This is the cheapness that we currently find in 10y swap spreads when assessed versus current repo metrics, periphery spreads and implied rates vol (see details of the regression in Exhibit 8. It is a level of cheapness that is also very similar to what was recorded in mid-Nov, just after the announcement of early German elections (see historical residual in Exhibit 9).

It is hard to determine what the fair value for 10y German swap spreads would be in the scenario where the debt brake is removed and the market assumes a permanently higher fiscal deficit, leading to a significant increase in the stock of German bonds.

However, we note that 10y OATs were able to trade at a spread as tight as 20-25bp vs Bunds for sustained amounts of time over the period 2015-2020, when French debt/GDP was already above 90% (c. 30ppt higher than current German debt/GDP). This could be a useful indicator as the max size of cheapening that German bonds could experience vs swaps as we fully price in the change in fiscal stance. Given the above cheapness, this would imply room for another c.5-15bp tightening in 10y swap spreads.

Effect on duration very uncertain, but pricing is optimistic

When it comes to the effect on duration, stemming from a potential reassessment of the growth outlook in Germany/the Euro area, we see the two tail scenarios as implying:

1. A potential c.20-25bp upside risk to our 10y swap forecasts (and thereby an overall c.35-40bp upside risk to our 10y Bund forecasts given the above swap spread cheapening), should a rapid and meaningful change to the debt brake be priced in. Near term this could imply an upside risk to Bund yields towards 2.75%. As well as an upside to our forecast of the trough in 10y Bund yields at sub 2% in 3Q25 of around 2.3-2.4%, which is still richer than current forwards of c. 2.55%.

This c.20-25bp upside to 10y swap rates would correspond to the potential upside to Euro area growth in a scenario of a 1ppt/year fiscal loosening in Germany with an optimistic fiscal multiplier of 1. As argued in the Economics section, we would have to think about the upside stemming from German fiscal only, as a change in the debt brake would likely come with reduced appetite for more fiscal at EU level.

2. A more rapid convergence towards our medium 2% 10y swap forecast and thereby to a sub 2% trough in 10y Bund yields, should there be a blocking minority against a reform of the German debt brake. Such a scenario would indeed make the market converge more rapidly to our economists' view that Euro Area neutral rates are likely closer to 1% than 2% and that the ECB would therefore need to cut the Depo rate to below 2% this year.

The above 'boundary conditions' for German 10y yields also illustrate why from a risk-reward perspective we struggle to see German debt brake reform as a tradeable theme in rate markets. Over and above the issues highlighted by our economists regarding the parliamentary majorities, timelines, and design of reforms, we face the issue that under reasonable scenarios even with reform, the potential upside risk to Bund yields gets overwhelmed by the monetary policy cycle which powerfully anchors rates.

We remain constructive EUR rates and see potential for German swap spreads to richen on debt reform disappointment, especially if additional issuance needs arising from the need for additional fiscal support in 2025 (via a change in the debt brake or use of escape clause) are funded by increased T-bill issuance rather than bonds.

  Rates - UK

• We enter a new pay March 2025 BOE MPC-dated Sonia. We do not see an accelerated cutting pace as possible before May (and even then unlikely).

Case sensitive

  We enter a new pay March 2025 Bank of England (BOE) Monetary Policy Committee (MPC)-dated Sonia trade at 4.397%, targeting 4.468% with a stop at 4.357%. Risk to the trade is a significant deterioration in the UK's economic outlook.

The MPC 7-2 vote split, with seven members voting for a 25bp cut and two for 50bp, caught the market by surprise. Formerly hawkish Mann delivered on her advocacy of an "activist" monetary policy strategy in joining Swati Dhingra with a call for 50bp.

The vote itself, in isolation, was certainly more dovish than consensus expectations, leading the market to price increasing probabilities of cuts at non-Monetary Policy Report (MPR) MPC meetings in future. For instance, the market is now pricing in 8bp of cuts for March, 19bp for May and 9bp for June, incrementally (Exhibit 10).

However, the Report itself told a completely different story, at least on our reading of it:

1. Most obviously, the forecast profiles for both growth and inflation were revised higher all the way out to the 3-year ahead horizon. The modal path for CPI inflation based on the market curve used by the Bank doesn't get to target until 4Q 2024. And the market curve used for the forecast was markedly higher than the prevailing curve today, suggesting that the inflation profile would have been higher still with a more up-to-date curve input.
2. Perhaps the most striking aspect of the Bank's inflation profile was that on unchanged rates (i.e., Bank rate kept at 4.5%), forecast inflation is still above target, at 2.1%, in two years' time. In older, simpler times, the two-year horizon was all important and a forecast above target would be read as signalling no further cuts, with a bias towards the next move being a hike.
3. In particular, we take issue with market pricing of 8bp cuts in March. The Bank's newly introduced scenario analysis, in which three alternative "cases" are presented, is perhaps most pertinent in this. Case 2 remains the Bank's most likely scenario (i.e., a period of economic slack is required to deal with inflation persistence), as in November. But the most dovish case for rates, Case 1, where remaining inflation persistence should dissipate quickly, was de-emphasised at this meeting. That, to us, dramatically reduces the likelihood of an imminent shift to back-to-back cuts.

4. Then there was the keyword message shift from "gradual" to "gradual and careful". If gradual means quarterly cuts, we would read the addition of "careful" as a qualifier to mean quarterly at most, without a material change in outlook.

5. The final argument that rules out a 25bp cut in March for us is the fact that a cut then would certainly send a signal of back-to-back cuts in the future, something the Bank may not be willing to signal without knowing the outcome of National Insurance Contributions (NICs), National Living Wage (NLW) and fiscal in March-May.

It is true that our own services inflation forecast profile undercuts the Bank's, but this difference only really reveals itself with the April number (published in May), where we take issue with the Bank's 5.1% services inflation projection (Exhibit 11). We do not see an accelerated rate cutting pace as possible before May (and even that seems unlikely).

For more, see BoE review: Next cut in May published on 6 February 2025.

 Rates - AU & NZ

• We recommend buying 2-3y SSAs given the yield pickup over semis/ACGBs and the supply profile of Kangaroo bonds. Unique regulatory dynamics make front-end, AAA-rated SSAs cheap in AUD.
• We also close our paid 5y5y 6s3s recommendation. Tailwinds from curve extension and seasonal supply dynamics are now fading.

Higher returns in front-end Kangas

We recommend buying 2-3y, AAA-rated Kangaroo (Kanga) bonds backed by supranational and government entities (SSAs) given 2-3y SSAs are trading especially cheap vs semis/ ACGBs. The flatness of the curve also contrasts with the recent trend of issuers to move further out the curve, driven in large part by the discount vs USD funding costs to issue at the long end of the curve & the premium over USD funding costs to issue at the front end of the curve (Exhibit 14). Risk: SSA spread widening driven by HQLA demand for semis/ACGBs. We also retain our long bias on a cross-market basis and AUD SSAs (like ACGBs/semis) look attractive vs USTs in the long end. Bottom line: we are bullish 2-3y AUD rates ahead of a RBA easing cycle, which our economists forecast will commence in two weeks, so we like buying SSAs outright or hedged vs semis/ACGBs/interest-rate swaps.

Close paid 5y5y 6s3s recommendation

Kangaroo bonds are bonds issued by offshore institutions in AUD. These issuers typically pay 6s3s as part of their hedging program, which also usually involves receiving interest-rate swaps and cross-currency basis swaps. In late 2023, we recommended paying 5y 6s3s starting on 19 November 2028 because the relative funding costs for longer-dated Kangaroo issuance over shorter-dated issuance had declined. This suggested Kangaroo issuers were likely to extend further out the curve and therefore pay longer-dated 6s3s than in previous years. A trend of longer-dated SSA issuance in 2024 is now starting to fade. Given issuance has also likely peaked on a seasonal basis (Exhibit 15), paying long-end 6s3s no longer looks as attractive as when we entered the trade. We entered the trade at 4.4bps with a target of 9bps. We closed the trade at 8.45bps.

Superannuation fund growth supporting Kanga issuance

Compulsory employer superannuation contributions to employee retirement savings accounts have steadily increased from 9% of gross salaries in 2013 to 11.5% today. The so-called 'super guarantee' is legislated to increase once more to 12% in mid-2025. Ultra-low unemployment and high population growth rates have also prompted rapid superannuation system growth. Although fixed-income asset allocation has remained stable around 12%, the absolute AUD value of fixed-income investment pools has increased fast - and absorbed unusually high Kangaroo supply (Exhibit 13).

Issuance profile makes front-end SSAs attractive

In 2024, the difference in funding costs for SSAs issuing in AUD vs USD became more pronounced in the long end vs the front end of the curve and this dynamic has persisted into early 2025 (Exhibit 14). In other words, the relative appeal of issuing 3-5y Kangaroo bonds has also diminished relative to longer-dated issues. Although this trend has started to fade, we saw a much higher proportion of 5y+ Kangaroo bond issuance in 2024 than in 2022/23 (Exhibit 16). It is therefore unlikely that a wave of new supply will cheapen 2-3y semis. February (and beyond) is also a good time to buy SSAs because SSA issuance is concentrated in January (Exhibit 17).

Unique regulatory treatment makes Kangas attractive

Kangaroo bonds issued AAA-rated supranational issuers provide a significant yield pickup relative to ACGBs, especially in 2-3y sector (Exhibit 12). The yield pickup relative to semi-government bonds and ACGBs is understandable given that SSAs cannot be held as high-quality liquid assets (HQLA) for the purposes of meeting Australia's Liquidity Coverage Ratio (LCR) requirements. The Australian Prudential Regulatory Authority's (APRA) decision to exclude Kangaroo bonds from LCR-eligible HQLA means the yield pickup on AAA-rated SSAs is higher vs semis/ACGBs than it might otherwise be. 2-3y Kangaroos therefore look attractive for asset managers and we like these bonds on an outright basis or hedged vs semis/ACGBs/interest-rate swaps (Exhibit 12).

  Rates - JP

•   BoJ did not sell JGBs with repurchase agreements despite dip in repo rate following recent hike to 0.5%
• We think BoJ will mainly use SLF to address collateral shortages

BoJ held off on selling JGBs with repurchase agreements

The BoJ raised its policy rate from 0.25% to 0.5% at the 23-24 January monetary policy meeting (MPM; for details, see Japan Watch: BoJ review: A 25bp hike, with more to come 24 January 2025). However, the repo rate stayed at 0.24% on 27 January, the trading day after the MPM, and plunged to 0.073% on the 28th before rebounding to 0.448% on 4 February. We think the BoJ is unlikely to sell JGBs with repurchase agreements even if the repo rate falls to near 0% again in the near future.

Structurally, IOER > TONA > repo rate

We received questions from investors about why the GC repo rate (overnight, T+1) remained well below the policy rate even after the January rate hike, and how the BoJ might respond.

The repo rate should be lower than TONA (the Tokyo Overnight Average Rate). Repos in Japan involve borrowing bonds with cash as collateral, and involve market participants who wish to borrow bonds and those who want to raise funds. Bond borrowers pay counterparties a borrowing fee, while lenders pay counterparties interest on collateral. The repo rate is the difference between the two (interest - bond borrowing fee). In other words, bond borrowing fees are the reason why the repo rate is lower than TONA.

Potential reasons for collateral shortage

Given that TONA rose to 0.47% the trading day after the BoJ's decision to raise the policy rate to 0.5% at its January MPM, we think the subsequent decline in the repo rate mainly reflects a lack of collateral. While it is hard to be certain, we think the shortage of collateral may reflect (1) the fact that the BoJ owns roughly 50% of all JGBs, and a particularly high percentage of 10yr and shorter maturities, and (2) the fact that fewer institutions may have been willing to lend bonds as they braced for the risk of the BoJ raising the 0.25% minimum fee rate for its securities lending facility (SLF).

Past BoJ's sales of JGBs with repos

The BoJ can supply JGBs to the market via its SLF or by selling JGBs with repurchase agreements to address collateral shortages that would drive down the repo rate¹. It continues to make offers under the SLF when it receives applications from one or more eligible counterparties², but has not sold JGBs with repurchase agreements since late March 2020.

When the BoJ sold JGBs with repos in March 2020, it noted that "Taking into account the abovementioned decline in financial market functioning and the increased demand for JGSs for the purpose of providing collateral, sales of JGSs with repurchase agreements intended to provide the market with JGSs were carried out for the first time in three years"³.

When the BoJ sold JGBs with repos in late March 2017 for the first time in around eight years, it explained that "[when] the Bank offers sale of JGSs with repurchase agreements, it absorbs funds from the markets, albeit temporarily, and the operations before November 2008 were carried out with this objective. However, it should be noted that the operations conducted this time was aimed at "supplying JGSs" in the repo market, where the supply and demand conditions for JGSs were tightening".

Conditions for selling JGBs with repos

Based on the BoJ's explanations about its past sales of JGBs with repos, we think it could do so again in the event of (1) a growing shortage of JGBs ahead of the fiscal year-end, or (2) an unexpected event like the COVID-19 pandemic.

That said, the BoJ did not sell JGBs with repos in 2023 despite a shortage of JGBs when the monthly amounts of successful bids under the SLF exceeded ¥100tn; even when the repo rate fell below 0% after it scrapped its negative interest rate policy (NIRP) in March 2024, it responded only with offers under the SLF. In short, it appears that the BoJ will mainly use the SLF to respond to dips in the repo rate.

BoJ uses SLF to address collateral shortages

On 24 January, the BoJ temporarily raised the cap on the number of JGB issues eligible for the SLF from 30 to 50 to avoid an excessive shortage of JGBs. On 16 January, the BoJ indicated that it would accept in principle counterparties' requests to reduce the amount of the cheapest-to-deliver (CTD) issues it repurchased under the SLF until the amount outstanding of each of the CTD issues in the market recovers to around ¥1.2tn.

Impact of selling JGBs with repos

The BoJ's monthly JGB purchases as a percentage of issuance rose from around 74% in March 2017 and 77% in March 2020 to a peak of 185% in January 2023, before falling to around 43% in December 2024. We therefore see little risk of the repo rate plunging to the -0.8% level it reached when the BoJ last sold JGBs with repurchase agreements in March 2020.

If the BoJ did sell JGBs with repurchase agreements, this would temporarily absorb several trillion yen from the market, but given its sizeable excess reserves of more than ¥460tn we would not expect this to have much of an effect beyond driving up the repo rate.

  Front end - US

• We expect to see bill cuts, EM used, and TGA dropped until the debt limit is resolved

Debt limit X-date estimate revised to late August

The debt limit X-date is a moving target that depends on several factors such as tax receipts and deficit spending. We will continue to tighten up our forecast as we learn new information on extraordinary measures (EM), TGA drawdown, financing needs, and unexpected spending (i.e. natural disaster relief). Following Treasury financing estimates this week & higher TGA we revise our X-date from mid- to late-August (Exhibit 18).

Extraordinary measures estimate little changed

The Treasury has been constrained by the debt limit since Jan 21 and has since used $132b of EM (as of Jan 29). Available EM will fluctuate and a EM decline is not necessarily permanent. Our EM estimate has largely been in line with Treasury's estimate thus far (Exhibit 19). We forecast that if the Treasury is at the DL through August, EM will total $536b, including a one-time increase in EM on Jun 30 of $147b.

X-date pushed backed with lower UST financing need

The X-date is when Treasury officially uses up available EM and the TGA. Using Treasury's updated financing needs from the Feb quarterly refunding, we revise our TGA and EM forecasts, which pushed our X-date back from Aug 15 to Aug 29 due to lower than expected financing needs and higher Jan TGA level. We still see any time beyond Aug 15 as high risk. Over time, we expect to see Treasury cut bill supply, use up EM, and spend down their TGA until the debt limit is resolved or the X-date is reached.

Higher tax returns => higher TGA => lower UST debt

The latest UST financing estimates implied a funding surplus for Q2'25, likely due to elevated tax receipts (Exhibit 20). Tax receipts grow the TGA & allow for Treasury to cut bill issuance or buyback debt. This will allow Treasury more time under the debt limit before hitting the X-date. Treasury's financing need forecast for Q2 is much more optimistic compared to our deficit forecasts so we see risk skewed to greater marketable borrowing and lower TGA, which would pull forward the X-date.

Our X-date forecast will remain highly uncertain until we are past the April tax date & have a better sense for US government revenues.

Last minute debt limit resolution most likely outcome

The debt limit debate has grown increasingly contentious throughout the years with the latest several episodes only being resolved within weeks of the forecasted X-date. Despite a push by President Trump to pass a debt limit resolution quickly, we believe it will be difficult to get enough Republican votes to increase or suspend the debt limit via the budget bill in March or a reconciliation package. Most debt limit resolutions require a bi-partisan resolution due to their unpopularity, difficulty of passage, & need to "share the blame" between parties. If Republicans need Democrat votes to pass a debt limit bill before the X-date, we believe it will likely be a last-minute debt limit resolution.

Bill supply to start trending lower in Feb

We updated our bill supply forecasts following the Feb refunding announcement to reflect the lower financing need in Q2, higher TGA trajectory, and estimates around remaining EM (see Feb refunding recap). We forecast $380b in bill supply over CY'25 but we're expecting significant cuts under the debt limit followed by a large wave of issuance once the debt limit is resolved (Exhibit 21). Our bill forecasts are heavily dependent on our expected debt limit resolution timing, which we currently forecast for late July. Between Feb and end July, we forecast over $800b in bill paydowns followed by almost $1tn in bill supply from Aug to Dec. The swing in bill supply will likely drive bills richer near term.

Bottom line: we push our debt limit X-date projection to late August following lower than expected Q2 UST borrowing need. We expect to see bill cuts, EM used, and TGA dropped until the debt limit is resolved. Once the debt limit is resolved, we expect to see heavy bill supply to rebuild TGA & cover UST borrowing needs.

   Supply - US

• We expect coupon size growth in Nov '25 but could slip to early '26. Auction growth likely proportional to current sizes.

Nominal coupon sizes stable, as expected

 Yesterday's Feb refunding was very close to our expectations (see refunding preview). Treasury announced stable nominal coupon auction sizes, as expected. Treasury kept the 30Y TIPS size unchanged & increased the 10Y TIPS size $1b, also as expected. However, the 5Y TIPS size was $1b larger than we forecast (Exhibit 22) TIPS auction size growth was done to "maintain a stable share of TIPS" as % of marketable UST debt. Overall, refunding communications did not offer any material surprise.

The refunding statement retained forward guidance language that UST "anticipates maintaining nominal coupon and FRN auction sizes for at least the next several quarters". This language was kept despite the TBAC report to UST Secretary that "uniformly encouraged Treasury to consider removing or modifying the forward guidance". Given TBAC's suggestion, we see elevated likelihood this language is modified or removed at the May refunding, consistent with an uncertain borrowing outlook.

Refunding communications make us comfortable with our baseline expectation for the next nominal auction size increases in Nov '25, though this could slip into '26. We expect auction size growth will be proportional to existing auction sizes and will leave WAM relatively stable. Our forecasts call for nearly $250b/y in deficit growth through FY '27 (Exhibit 23); such elevated financing needs will require coupon growth in the next 1-1.5Y to angle bills / marketable debt lower over time. We assume Fed QT through end Q3 '25 which will add to UST private borrowing needs.

Bill issuance: swings with the debt limit

The refunding statement noted that debt limit dynamics will "result in greater-than-normal variability in benchmark bill issuance and significant usage of CMBs". We expect this variability and project that there will be over $800b in bill supply cuts from today through July. We think bill supply cuts are likely most concentrated in Q2 '25 with over $170b in paydown each month. We continue to believe bill cuts will support stable funding, richer USTs vs OIS, and slightly wider front end swap spreads in 1H '25. These dynamics should fully reverse in 2H '25 after debt limit resolution with nearly $1tn in bill supply from July onwards.

Our base case assumes debt limit resolution near the X-date, though a range of outcomes are possible. Our X-date projection was pushed out slightly into late August (from mid-August) due to Treasury's lower than expected Q2 financing estimate. Treasury appears to have quite optimistic assumptions about April tax revenue. The debt limit will remain a key factor in driving bill supply & funding markets over '25.

Treasury cash balance: no sign of change

Treasury's cash balance (TGA) received little attention at this refunding. In the financing estimates released Monday, Treasury assumed a stable TGA of $850b at end March & June, conditional on debt limit resolution. There was no mention of potentially targeting a lower TGA in the quarters ahead.

We continue to place a low likelihood of meaningful TGA drop. A TGA shift is possible with new Treasury leadership (as discussed in UST TGA: risk of lower cash balance). However, prudent liquidity risk management considerations are likely to limit the extent of any potential TGA changes. The limited discussion of TGA policy changes at this refunding reinforces our view.

Bottom line: the February refunding was very close to our expectations. Forward guidance of stable auction sizes over the next "several quarters" remained, though TBAC opposition raises the odds it is adjusted or removed at the May refunding. We stay comfortable with our baseline of coupon size growth in Nov '25, but it could slip to early '26. Treasury signaled upcoming bill swings that will be substantial over '25 (we expect 1H = big bill cuts, 2H = larger bill growth). Treasury offered no sign of TGA change.

     Volatility - EU

• We maintain a structural bullish bias, maintain current hedges & present two new trades: (1) 6m5y 1x1.5 receiver spd; (2) long 9m30y US OTM payer spd, funded by the sale of a 9m30y EUR OTM payer.

Recent vol dynamic

Expectations for ECB easing generally drive volatility lower, but it is noteworthy that vol has traded broadly lower even as 10y rates sold off from the early December lows, likely expressing greater conviction around a c.2% terminal ECB rate - as opposed to risks of sub neutral rates in response to a growth shock and lower inflation (Exhibit 24).

That said, in our last EUR Vol report (see EUR Vol from 5 Feb '25), we note that 1m gamma in the belly/right side stayed supported, even as the rest of the grid drifted lower with the left side leading. On a 3m-ZScore basis, the EUR vol grid looks broadly cheap. On the PCA framework, the least cheap point in gamma is 6m5y. Implieds trade rich to delivereds on the right side. Payer skew looks broadly cheap vs receiver.

Trade recommendations

We continue to like receiving Dec ECB €str (see European Rates Alpha) (current: 1.79%, target: 1.3%, stop: 2.05%) to express our view of a lower ECB terminal rate. Risk = upside surprises in inflation prints. We now also enter a costless 6m5y 1x1.5 receiver spread with strikes atm-30bp /atm-44bp, in line with our forecasts implying a trough in 5y swaps 45bp below fwds in 3Q25. We target 14bp, with -7bp stop. Risk = rally beyond downside breakeven of 1.5%.

We maintain our OTM 2s10s bull flattener, expiring in April (current: 90K, stop: 0K - see EUR Vol, Oct-24). Downside risks to growth can support some near-term flattening vs fwds as markets remain concerned about an inflation uptick. Also, to hedge inflation risks, we stay tactically paid Mar ECB €str (see 24 Jan GRW) (current: 2.41%, target: 2.55%, stop: 2.37%) and in our EUR 3m2y payer fly (see 17 Jan GRW) (current: 6bp, target: 35bp, stop: 2bp). The risk to these trades = lower inflation or a shock that leads the market to price in larger/rapid cuts.

Cross market, we buy a US 9m30y OTM payer spread (atm+20/atm+60bp) fully funded by selling a EUR 9m30y OTM payer (2.5% strike). This is to express our view of general US rates underperformance vs EUR rates + potential for PF receiving in EUR long-end on a large sell-off (dynamic hedging). The position is long duration & short vol at inception (path of least resistance for EUR & US rates, see Lagging directionality). At the same time, it hedges the bearish scenarios medium term. We target 800K, with stop at -400K. Risk = underperformance of EUR vs US rates, on larger US risk-off.

  Technicals

•  The short-term top patterns in US yields we flagged in late January have led to a decline thus far in February. For 10Y yield, it suggested a decline to +/- 4.30%.

US10Y yield declined as head & shoulders top suggested

In the Rates Technical Advantage (Jan 27 2025) and the Global Rates Weekly (Jan 31 2025), we discussed top formations in US yields, such as the head and shoulders top in US 10Y yield. This week, yields declined in line with this pattern that estimates a decline to about 4.30% or near the 200d SMA. It will be important to assess market actions here because yield will be retesting the trend line from the Oct 2023 peak and 200d SMA. If yield bases here, then it still stands a chance of retesting 5% before US Memorial Day. However, below this and a larger decline like that following the head and shoulders top in 4Q23 may be underway.

  Special topic

• We discuss a framework to estimates how the likelihoods of different macro scenarios are reflected on an asset's dynamic. We apply this framework to 10y BEs and the relative dynamic of EM Corp credit spreads, IG Cash & IG/HY CDX vs. 10yT. Our bias is to see extremes in the likelihoods estimated through this framework as a driver for tactical contrarian positions.

The utility of directionality indicators

In directionality indicators we decompose the dynamic of an asset in terms of its fundamental moves. Because each of these moves can generally be mapped to different scenarios for the outlook, we can use the recent frequencies for these fundamental moves as proxies for the likelihood that the market may be assigning to the different scenarios. Our bias is to see extremes in the likelihoods estimated for the different macro scenarios as a driver for tactical contrarian positions.

10y BEs

Orthodox moves in the dynamic of 10y BEs = bear widening (expansion moves) & bull tightening (slowdown moves). Market seems to be pricing c.80-85% likelihood of expansion scenarios (Exhibit 27). We favor fading this optimism tactically (see Exhibit 28 and Lagging directionality from 21 Jan '25).

EM corp credit spreads vs. 10yT yields

Orthodox moves in the relative dynamic of EM Corp credit spreads vs 10yT = bear tightening (expansion) & bull widening (slowdown). Expansion likelihoods for the US economy (c.80-85%) seem to be running ahead of those for EM (c.55%), with the latter likely reflecting a pickup of uncertainty on tariffs (Exhibit 29).

IG Cash spreads vs. 10yT yields

Orthodox moves in the relative dynamic of US IG/HY credit spreads vs 10yT = bear tightening (expansion) & bull widening (slowdown). The IG Cash dynamic suggests currently lower expansion likelihoods (c.45-50% - Exhibit 30) likely reflecting the recent headwinds to spread products and risk from a pickup of political and policy uncertainty.

Relative dynamic of IG/HY CDX vs. 10yT

The normalized frequency of expansion moves in the dynamic of IG Cash faded recently ahead of the ones extracted from IG CDX (Exhibit 31). A comparison of proxies for the likelihood of expansion scenarios extracted from the relative dynamic of IG and HY CDX vs. 10yT reveals a high correlation between the two gauges (c.87%) and only sporadic decoupling. Significantly, we see higher historical frequencies of unorthodox moves in the relative dynamic of IG/HY CDX vs 10yT (only c.55% frequency of orthodox moves), and higher than average frequencies more recently suggesting the potential impact of both valuation limits & a shifting dynamic with Fed expectations.

Limits to the analysis

The proxies for the likelihoods of expansion & slowdown scenarios calculated in this framework need to be interpreted against: (1) the frequencies of unorthodox moves (higher unorthodox frequencies limit the level of confidence on these estimates - see Exhibit 33); and (2) the shifting sensitivity of asset's dynamics to Fed policy expectations.