Our medium term views

 Our key forecasts

  What we like right now

  The View

  The focus next week should shift to soft data for May, with PMIs across the US, UK and Euro Area, as well as INSEE and IFO for France and Germany respectively. A key source of uncertainty for this set of releases is the sampling period relative to Monday's announcement of a US-China détente in the trade war, which may limit any market reaction.

We stick with our core convictions of a bullish bias in EUR rates and fading near term Fed cuts (see below). These trades may also be supported by a growing focus on the deficit and our economists' view that deficits are likely to keep increasing: we stay short 30y USTs on ASW and in conditional bear steepeners.

We expect the RBA to deliver a hawkish cut next week, even if this week's labor market data was probably more noise than signal (see Australia Watch 15 May 25). We recommend selling Dec '25 bill futures, buying 3y bond futures as a hedge.

Next week also sees inflation data from Canada and the UK. Our economists have flagged how the weak Canadian labor market report is consistent with further cuts from the BoC, contingent on inflation correcting. UK inflation data will be heavily influenced by energy bills, National Insurance Contributions and others, but our economists are looking for an undershoot vs the BoE's forecast.

Finally, we get March current account data for the Euro Area. While likely to be distorted by tariffs, we take the opportunity to flag the underlying structural story, whereby the EA current account surplus has been funding the US current account deficit (see Liquid Insight 14 May 25). In the context of the US's very large and negative net international investment position we would argue that this makes TIPS look expensive cross market and EUR forward real rates cheap, we receive 5y5y real €str (see Rates EU).

The week that was

The US and China announced a significant de-escalation of tariffs over the weekend in another major reversal since 2 April (see US Watch 12 May 25). This has generally been supportive of our implicit short vol trades flagged last week: paid July FOMC, short 1y inflation, 2s10s flatteners (see US Rates Watch 13 May 25). We close our 1y inflation short and enter a Z5-Z6 SOFR flattener, add paid Dec FOMC OIS and add 10s30s steepeners.

Paul Ciana points to further upside risks in US yields on the back of the post China deal price action. The daily chart of 2Y yield may be repeating the bottom formed in Aug-Oct 2024. The 5Y, 10Y and 30Y yields all formed uptrend continuation patterns and show uptrend signals from the MACD indicator. After a dip in US 10s30s, we see the curve steepening to 55-65bps (see Technicals).

US data supported the front-end with a soft retail sales number (though seasonals are likely a factor) as well as soft PPI. Meanwhile, UK GDP and Australian labor market data came in better than expected. We closed our paid RBA OIS position (at target) and our received MPC SONIA position (at stop).

  Rates - US

•       We are underweight rates near term as market pares back '25 recession risk
• We are now paid Dec FOMC OIS, like Z5-Z6 flatteners, & 10s30s steepeners

Liberation day rate drop now fully retraced

US rates rose & the curve bear flattened with US-China tariff de-escalation & reduced downside US growth risks (see White smoke in Geneva). Lower recession risks prompted a paring back of Fed rate cuts, especially in 2H '25 & '26 (Exhibit 4, Exhibit 5). US rates & recession probabilities have fully retraced their post "Liberation Day" moves.

Investor feedback implies a big shift in market narrative away from "inflation, recession, & depth of Fed cuts" to "growth, fiscal, & if Fed needs to cut". We try to lean against large swings in market narratives but believe the recent rate move has momentum.

Our updated views: duration = be tactically underweight as market further pares back recession odds; we recommend fading '25 rate cuts (stay paid July FOMC OIS, add paid Dec FOMC OIS (entry: 3.77%, target 4.25%, stop 3.5%) & stay underweight UST long end. Risk to these trades would be a downside economic shock that would pull forward cuts into '25. Curve = Z5-Z6 flattener with pricing out of near-term Fed cuts & pushing cuts into '26 w/ falling inflation; we also add 10s30s steepeners given increased focus on fiscal (entry: 45bp, target 70bp, stop 15bp); risk to this trade would be cuts to fiscal spending / lower projected deficits. Spreads = stay short 30y asset swap spreads with ongoing UST supply / demand imbalance; hold constructive stance in 2y & 5y front end spreads with stable funding / bill cuts. Funding = long July SOFR/FF. Inflation = long 2y3y inflation. Vol = favor forward vol proxies including conditional 5s30s steepeners.

We hold our current US rate forecasts stable but acknowledge upside risks. Our end '25 forecasts: 2y = 3.75%, 10y = 4.5%, 30y = 4.9%. Our forecasts vs forwards: 2Y f'cast now below forwards (3.87%) but 10 & 30Y in-line.

For the remainder of this note we provide perspective on broader market moves & offer guidance for when to lean against recent rate rise.

Cross market step back: risk on, USD off, rates mixed

We step back to re-assess market signals after a very volatile start to the year. This perspective may help navigate markets going forward.

To assess market signals, we look at key indicators & major asset classes and where they are in their YTD trading range + % of retracement off YTD lows (Exhibit 6). Our takeaways: (1) US equities are looking beyond lingering trade uncertainty (2) DXY & CL1 have persistent impact from US economic policy shifts (3) US front end / belly rates still bake in near-term Fed cuts while the US long end suffers from supply / demand concerns (4) EU equities & rates price better growth & higher supply.

These price moves suggest: (1) scope for further US rate rise, esp. at the front end (2) risk of DXY sentiment shift if US growth rebounds & trade uncertainty falls. We discuss.

Scope for further US rate rise: clients have started to ask how far rates can rise if growth solid & focus shifts from trade to fiscal policy. Our simple framework: we expect the market to place very low odds of Fed rate hikes which means the SOFR OIS path will likely be capped by the overnight rate. In fact, the YTD highs of SOFR OIS in 2-10y tenors is between 4.2-4.3%; the 75^th pctl a similar range is between 4-4.1%. This implies scope for another 10-30bps rate increase to price back to the 75^th pctl, with the biggest moves in 2-5y tenors since 10y OIS is getting closer to YTD highs. Near-term clients should consider expressing longs at the 10y point & defer front end / belly longs until Z6 is closer to 3.75% & 2-5y OIS are closer to 4-4.1%. This would likely see 2-5y UST yield levels at 4.25-4.35%. Higher rates have momentum (see Deals for yields).

DXY risks: Our FX strategists are still bearish USD (see Still bearish USD) but negative USD sentiment is stretched (see FX & rate survey). Views on the USD matter for possible diversification away from US assets, including USTs. Clients have increasingly questioned how much diversification away from USTs is possible, esp that could find its way to Europe. To approach the question, we consider trends in foreign allocations to USTs (Exhibit 7). If we assuming a rapid 1-time position adjustment akin to the fastest historical reduction of foreign holdings as % of total USTs outstanding, it would imply a UST drop of ~$550b. We acknowledge this is quite sharp and foreign UST holdings typically do not adjust that quickly; we offer the approach as one framework to consider.

We are generally of the view that capital chases returns. Therefore, if US growth starts to outperform ROW we expect USD sentiment will shift. This would imply a lower potential reallocation of US assets & less dire outlook for US rates vs current sentiment.

Bottom line: we are underweight rates near term due to a reduction in recession risks. We are most confident to be paid the US front end (fading of '25 rate cuts) & under-weight the back end due to fiscal expansion & supply / demand dynamics. We think belly longs are more compelling with Z6 around 3.75% or 2-5y OIS 4-4.1%; Z5-Z6 is another way to position for pushing out of Fed cuts to '26 with inflation drops. US asset pessimism is high; if US growth remains resilient global UST sentiment may shift.

  Rates - EU

• Diverging US and Euro IIP/GDP ratios, overlaid with the de-dollarization story, favour Euro rates (both outright and on a relative basis). We would receive 5y5y "real €str".

Global imbalances story gets "de-dollarization" makeover

A year ago, we argued that the conventional wisdom that the "global savings glut" had been the driver of lower yields needed reframing. We said that:

"…it wasn't necessarily the income effect (more savings). We're convinced the substitution effect was at least as important - global imbalances leading to savings accumulating in surplus countries' reserves that were then recycled into government bonds. Private savings, with a healthy risk appetite, were crowded out by risk averse public savings."

 '"Substitution effects" of the global savings glut go into reverse', 30 May 2024

We went on to argue that the substitution effect was unravelling, and that this would lead to a greater yield penalty to be paid by countries with high dependency on foreign capital, notably the US, and benefit the providers of that capital, notably Europe. This was not because the imbalances were shrinking (far from it), but because Europe was emerging as the dominant creditor and Europe is not a reserves accumulator - overseas assets purchased are almost wholly privately-held and likely to be more diverse and farther out along the risk frontier. And it had also been clear for some time that even reserve accumulators were seeking to diversify away from government holdings, and this is now entangled with the hot debate over "de-dollarization".

A world where Europe is the marginal provider of finance to the US…

Exhibit 8 and Exhibit 9 are reworked charts from the IMF's World Economic Outlook (WEO), showing country International Investment Positions (IIPs) as a share of global GDP. We show the same chart from WEOs published last month and October to highlight that the imbalances have been revised larger. This adds weight to our argument that US assets will need to offer increased prospective real returns relative to the Eurozone.

The widening gap between the US's and Eurozone's IIP/GDP ratios has been dramatic (Exhibit 10). Q4 alone delivered a 9% increase in the spread. Exhibit 33 updates our usual relationship between economies' IIP/GDP ratios and their 10y linker real yields. It shows the US now looking quite expensive by this metric, even before allowing for the likelihood (in our view) that the US IIP situation deteriorates further, without either a radical improvement in the current account position or dollar weakness sufficient to revalue the US's overseas assets relative to its liabilities.

This favors Euro real (and nominal) rates, both outright and cross-market

In linkers, the specific expression we have been recommending recently is to extend, in equal cash value amounts, from the 2033 BTPei issue into the 2039 issue. By doing this "cash-for-cash", the trade effectively receives the forward real yield between the two issues. We recommended this at a forward yield of 358bp last month, setting a target of 300bp and a stop-loss at 400bp (currently 350bp). Risk to the trade is general Italy cheapening. See 'Spring Forward', Inflation Strategist, 1 April 2025.

The small reduction in the forward yield has been a function of Italy richening - the equivalent forward real swap rate has risen slightly. In Wednesday's Liquid Insight, we recommended combining a 5y5y €str position with a 5y5y Euro inflation swap to receive a forward "real €str" rate of 74bp, setting a target of 25bp and a stop-loss of 100bp (currently 67bp). Risk to the trade is robust economic growth.

Why the 5y5y real rate?

In part, we'd suggest that a 5y5y real rate is sufficiently far forward to represent "neutral", and 74bp is somewhat higher than we believe is fair for a Eurozone r*. But it also represents almost the peak of the forward real rate map, with attractive roll-down.

   Rates - UK

• We expect banks reserves at the BoE to amount to c. £640bn by end-2025 and £580-610bn by end-2026, depending on QT pace outcome from October.

 BoE reserves to amount to £580-610bn by end-2026

We expect banks reserves at the BoE to amount to around £640bn by end-2025 and £580bn by end-2026, if QT continues at a £100bn/year pace from October, from £689bn currently (Exhibit 14). An alternative scenario with a QT pace reduction to passive-only from October 2025 would imply around £640bn by end-2025 and £610bn by end-2026. Both forecasts assume a steady transition towards a repo-led reserve demand operating framework, where the decline in reserves due to the ongoing QT and TFSME unwind is steadied by reserve provision through STR and longer-term repo (for example, ILTR).

BoE repo to offset about half QT/TFSME reserve drain

As reserves become scarcer, UK bank usage of the BoE's repo has grown to around 45% of the QT and TFSME drain in recent quarters (Exhibit 15). Our estimates assume repo usage continuing to offset around half the drop in reserves until end-2026 (Exhibit 16 and Exhibit 17). As has been the case so far, the increase in BoE repo facility usage will not be gradual: banks' balance sheet restrictions around specific reporting dates will likely continue causing some volatility in repo take up (Exhibit 18 and Exhibit 19). The BoE is also still in the process of reviewing the calibration of the ILTR to ensure its effectiveness and attractiveness to support a potentially large provision of reserves.

BoE QT: to slow or not to slow

The Bank did not reveal much on the future QT pace in the MPC press conference, with Dave Ramsden saying that the process to consider the next year's QT will "start soon". At the latest, the Bank should publish its process review in the August MPR and could implicitly signal a QT pace change, if it decided that would be appropriate (for example, if the BoE were to conclude that the effects of QE and QT were more symmetric than previously assumed). In addition, the conclusion of the ILTR calibration review will be important for the future success of the BoE's demand-driven reserve system; we judge it to be successful so far but wonder about the Bank's medium-term preferences for borrowed reserves distribution between STR and ILTR. For now, we do not pick a base case scenario for QT - the discussion deserves a separate Viewpoint, we think. But the seemingly one-sided nature of the outcome (we would be shocked if the pace increased from October) aligns with our constructive stance on long-end Gilts relative to swaps.

Sonia and repo market implications

Sonia flatlining at 5bp below Bank rate from April to December 2024 was striking but not unexplainable. However, the steady liquidity drain meant that Sonia would resume its upwards drift at some point. We expect the Sonia/Bank rate spread to gradually tighten to 0bp, as the ongoing reserve reduction results in some banks seeking alternative liquidity sources in the Sonia market, with some also adjusting their deposit pricing higher in a more competitive environment. Any reluctance to use facilities (eg. ILTR), regardless of economic merit, might curb unconstrained take-up and market intermediation, driving shorter-term funding volatility. We see risks skewed to the upside for Sonia relative to Bank rate, i.e., Sonia exceeding Bank rate slightly, if the imbalance between reserve demand and supply is greater than expected.

Increasing funding demand by banks as liquidity declines, banks' balance sheet restrictions around specific reporting dates and the extent of perceived stigma around reliance on central bank funding, together with the persistently high Gilt supply outlook, are some of the upside risks to repo relative to Bank rate. Positioning is harder to predict, but a long bond stance by leveraged investors who sustain funding demand in repo could also contribute to upward pressures on repo-Sonia rate spread. On balance, we expect repo to continue trading with more volatility and at a positive spread to Bank rate, with risks skewed towards more spread widening.

 Rates - AU

Cautious 25bps cut

 We expect the Reserve Bank of Australia (RBA) to cut the cash rate target by 25bps from 4.10% to 3.85% at its May meeting, in line with consensus and market pricing. The statement and press conference are likely to suggest a cautious approach to easing. Inflation and wage data for Q1 were broadly in line with RBA expectations, but softer momentum in consumption and downside global growth risks support a 25bps cut. The press conference would likely strike a similar tone to the February meeting, where the Governor emphasized a cautious approach and uncertainty around the inflation and growth outlook. We expect near-term growth forecasts to be revised down, but inflation and unemployment forecasts will be little changed.

Stay short in the front end, hedge by buying the belly

We recommend selling Dec '25 bill futures vs 3y bond futures (YM contract). The risk of a hawkish surprise next week is underpriced. Market pricing has moved but still looks rich: August is still pricing in slightly more than two full cuts (52bps) and 78bps by November. We see fair value for August as closer to 40/45bps and 60/65bps for November. In other words, market pricing of the probability of an August and November cut should be roughly 50-50 given the skew of local and global risks.

Ordinarily, we would recommend selling Sep '25 bill futures vs YM because this contract should exhibit a higher sensitivity to the RBA's decision and communications next Tuesday but the bills-OIS basis (BOB) curve is unusually steep between June and September (Exhibit 21). Consequently, investors are likely to enter June/ Sep '25 BOB flatteners for carry, placing downward pressure on Sep '25 bank bill yields.

A safer expression is to sell Dec '25 bill futures, hedged by buying YM. In addition, Dec '25 bill futures have not fully retraced levels last seen earlier this year. We enter the trade at 21bps, targeting 8bps (i.e. a retracement to November/ December 2024 levels) with a stop loss of 27bps. Risk: a dovish (mis)communication by the RBA next week.

Why will the RBA move more slowly than mkt pricing?

Large cash rate movements (e.g. 50bps cut in May) are optimal when the policy rate is far from the desired level, but when global trade policies are highly uncertain (i.e. tariff rates could be much higher or lower than today over the next few months) and we believe a more cautious approach is warranted. The RBA in unlikely to pre-emptively lower rates given two-sided risks around US and China trade policy (i.e. tariff rates could be shifted higher or lower than today over the next few months).

Moreover, the starting point - underlying inflation above target, unemployment rate below the NAIRU - also suggests the RBA can adopt a gradual easing approach. In so doing, the RBA would follow the precedent set by policymakers at recent Bank of Canada and Reserve Bank of New Zealand meetings. have adopted a similar approach at their most recent monetary policy meetings.

We expect the RBA to cut by 25bps in May and November, and don't believe the current outlook and elevated policy uncertainty warrant more than a quarterly pace of cuts. The primary risk to this view would be a weak quarterly CPI print at the end of July, prompting an August RBA rate cut. This means the realistic downside to our easing path (25bp rate cuts in May and November) is an additional rate cut in August, absent an imminent global emergency.

Federal fiscal impulse leads to growth tailwinds

A drop in real wages over the past few years has increased pressure on Australia's governments to deliver cost-of-living relief (Exhibit 23). More expansionary fiscal policy is also an upside risk for RBA policy rates. The Australian Labor Party (ALP) is currently leading the vote count in 93 of 150 seats in the lower house, their largest majority since World War II.  The strong majority will give Prime Minister Albanese a mandate to implement Labor's policy agenda and poses an upside risk to spending.

We expect a positive fiscal impulse at both the Federal and state levels through 2025, due to Labor focusing on cost-of-living, housing, healthcare, and energy, while the state's drive substantial infrastructure investment with positive spillovers to private activity. We have turned more negative on spreads and recommend (see Australia Viewpoint, 15 May 2025). We recommend buying TCV 5.5% Sep 2039 bonds, paying 10y swap (entry 133bps, target 100bps, stop 148bps). The 3m carry and roll of this structure is +2bps. Risk: wider semi spreads in a policy-driven, risk-off event.

  Rates - JP

• Superlong JGBs briefly rallied after 13 May 30yr auction, but structural concerns about supply/demand remain. We do not expect BoJ or MOF to intervene in JGB market in near future.
• Thus, we recommend 5s30s steepener in JGBs via long JGB #178 maturing 20 March 2030 vs. short JGB #86 maturing 20 March 2055.

What can BoJ/MOF do about steepening yield curve?

Superlong JGBs rallied after the 13 May 30yr auction, but supply/demand concerns remain. However, we would not expect either the Bank of Japan (BoJ) or Ministry of Finance (MOF) to intervene in the bond market in the near term, and we therefore expect the JGB curve to face renewed steepening pressure ahead of the scheduled 20yr auction on 20 May and 40yr auction on 28 May.

What action can BoJ/MOF take?

While both the BoJ and MOF have tools for curbing rising yields when the JGB curve steepens, we think they are unlikely to intervene in the near future.

Relatively low hurdle to pooled collateral operations

The BoJ could respond to rising yields by (1) conducting Funds-Supplying Operations against Pooled Collateral, (2) increasing outright JGB purchases (rinban), (3) conducting fixed-rate purchase operations, and (4) adjusting the maturities it buys in outright purchase operations.

• Increase rinban purchases, fixed-rate buying ops: The BoJ is currently reducing JGB purchases by around ¥400bn per quarter. It would therefore find it difficult to explain an increase in outright purchases or fixed-rate purchase operations to the bond market while it continues with de facto quantitative tightening (QT).
• Adjusting maturities in rinban ops: The BoJ's outright JGB purchases are skewed toward 10yr and shorter maturities, and it buys just 14% of monthly issuance of 25yr and longer maturities. We therefore think the BoJ could increase its monthly purchases of these maturities from the current ¥150bn while continuing to reduce its buying in overall terms. However, one policy board member argued in the Summary of Opinions for the last monetary policy meeting (MPM), released on 13 May, that the BoJ should not overreact to expectations for superlong yields to rise¹.
• Funds-supplying operations: We think the BoJ would find it relatively easy to use its Funds-Supplying Operations against Pooled Collateral to drive down yields without directly buying JGBs as it continues with de facto QT. However, the lending period for these operations is 10 years or less, so in their current form they are unlikely to drive down superlong yields.

MOF would likely intervene by reducing amount per auction

We think MOF's options for responding to a steeper JGB curve are reducing (1) the amount per auction or (2) the frequency of auctions. We think the former is more plausible, but both are unlikely in the near term.

Revisiting FY23 cuts to 20yr JGB issuance

Past examples of MOF reducing JGB issuance in the middle of a fiscal year include its cut to 20yr issuance in FY23. This was driven by the BoJ's move to a more flexible yield-curve control (YCC) regime. This prompted a jump in the 10yr yield and a shift in Japanese banks' demand from 20yr to 10yr issues. MOF announced on 22 December 2023 that it would reduce 20yr JGB issuance by ¥200bn starting from the January 2024 auction to respond to the chronic lack of demand.

However, MOF does not make these changes to issuance plans out of the blue. If it intends to revise its plans in the middle of the fiscal year, it first convenes a Meeting of JGB Market Special Participants attended by major banks and brokerages to hear their views on JGB supply/demand. When MOF cut 20yr JGB issuance in FY23, it held one of these meetings on 6 December 2023 to hear market participants' views on cuts to 20yr issuance during FY23 as well as its forthcoming FY24 JGB issuance plans.

No recent meetings on cuts to superlong issuance

The most recent market participants' meeting on 21 March mainly discussed the reopening method/auction format for fixed-coupon bonds and JGBi issuance, and did not touch on cuts to superlong JGB issuance. We therefore see a reduction in superlong JGB issuance as unlikely in the near term.

We also see think several factors would make it more difficult to cut superlong JGB issuance in the near term: (1) the high-profile debate on the merits of a consumption tax cut ahead of the Upper House elections (expected on 20 July), (2) the lack of visibility on FY25 tax revenues given that the new fiscal year has only just started, and (3) the fact that MOF has already reduced annual 40yr and 30yr JGB issuance by ¥1.2tn each since April.

When could MOF reduce superlong issuance?

Even if MOF were to cut superlong issuance during FY25, we would not expect it to do so until at least Oct-Dec. On 13 May, the secretaries-general of LDP and Komeito stated that they think an FY25 supplementary budget will be needed this autumn. If this budget is drafted on the usual schedule, we would expect MOF to hold a Meeting of JGB Market Special Participants around Oct-Nov to hear views on supply/demand for individual maturities. If bond market participants indicate looser supply/demand for superlong JGBs, MOF could scale back superlong issuance.

Trade recommendation

The result of the 13 May 30yr auction was not as weak as the market expected, and JGB #86 was bought on dips at just below 3%. However, this does not mean that the chronic shortage of demand has eased, and we expect renewed steepening pressure on the JGB curve.

Medium-term yields rose following the US and China's agreement to reduce tariffs, and the 5s30s spread narrowed to around 190bp, but we expect it to widen again, given the 20yr auction on 20 May and 40yr auction on 28 May.

Thus, we recommend 5s30s steepener in JGBs via long JGB #178 maturing 20 March 2030 vs. short JGB #86 maturing 20 March 2055. We enter the trade at 198bp, targeting 215bp with a stop at 189.5bp. Risk includes the BoJ and MoF's intervention in the bond market.

 Front end - US

• Debt limit is again relevant; UST Sec does not have confidence to meet obligations beyond Aug, as we expected
• Debt limit matters b/c (1) headline risk about UST default (2) large swings in bill supply & money market rates

Debt limit FAQ

Clients have questions on the debt limit and impact on markets. FAQ below.

The debt limit caps outstanding US federal debt, currently at $36.1t. The debt limit was suspended in June '23 until Jan 2 '25 when the new debt limit was established. It forced Treasury to enter a debt issuance suspension period (DISP) where it is limited to its cash balance and extraordinary measures to meet its outlays. Treasury can still issue to replace maturing debt in addition to headroom from extraordinary measures.

On Friday Treasury suggested "there is a reasonable probability" that debt limit "measures will be exhausted in August". The CBO currently projects this so-called "X-date" will hit between mid Aug - mid Sep. Our point estimate is that Treasury can fund itself until mid-Oct but we agree available resources get very low in late August.

Our baseline is the debt limit will be resolved prior to a technical default. We expect the debt limit will be increased in late July / early August with only Republican support, but other options are possible. We see a very low probability of a potential breach of the X-date.

Short term funding markets should be sensitive to debt limit dynamics. Some investors avoid potentially impacted bills and short UST coupons as we approach the X-date. We expect a bill curve kink to form in the second half of August based on Secretary Bessent's guidance. Other money markets may also be impacted.

Once the debt limit is resolved, we expect Treasury to issue a large amount of bills to rebuild their depleted cash balance. This bill supply will likely lead to bill cheapening and see the Fed's overnight reverse repo facility (ON RRP) fully drained. Investors should see bills and other money market rates cheapen with the increase in UST supply.

In this note, we address the following topics:

• Debt limit 101
• Debt limit specifics
• Debt limit unthinkable events
• Debt limit market impact
• Life after the debt limit is resolved

         Front-end - EU

• Interest in European assets rose and may lead to capital inflows to the euro area; banks may see their net external assets rise and this could raise broad money supply
• Inflows would be another source of front-end pressure supporting wider Euribor-€str and tighter EUR FX-Sofr

 How inflows can widen front-end spreads

Interest in euro assets so far this year has been supported by 1) Germany's fiscal paradigm shift, 2) premium on US assets after the US' reciprocal tariff announcement, and 3) the central bank diversification theme. In May, global fund managers became the most overweight Euro area vs US equities since October 2017 (see Global Fund Manager Survey, 13 May 2025). This is consistent with the stronger inflows to European equity funds recorded in recent weeks than those to US equity funds (Exhibit 24).

A broad rotation by global investors to European assets may lead to capital inflows to the euro area. In the Rates market, such rotation may be supported by continued rate divergence between the Fed and the ECB, which could make EGBs even more attractive vs UST on a rolling FX-hedged basis (Exhibit 25, see Global Rates Weekly, 2 May 2025).

Capital inflows to the euro area will increase euro area banks' net external assets. Since 2022, euro area banks' net external asset growth has been supported by net portfolio inflows in addition to the current account surplus (Exhibit 26).

An increase in banks' net external assets would raise their net domestic liabilities. Some of these domestic liabilities, in particular deposits and bank debt, would be captured in measures of broad money. We have been concerned about the recent divergence between broad money and base money in the context of euro area banks supporting their HQLA portfolio as the ECB continues QT (Exhibit 27, see European Rates Watch, 25 Apr 2025). Broad money growth driven by capital inflows may add to this divergence.

It may be increasingly difficult for banks to make daily payments on behalf of their clients as broad money rises and base money declines over time. The ratio of broad money to base money is back to May 2020 levels, even though excess liquidity is c. €600bn higher than then (Exhibit 28). This could cause reserve demand to exceed supply sooner than expected by the market, and would be a source of widening pressure on front-end euro spreads.

We stay in 1y1y Euribor-€str wideners (initiated in Nov 2024, current: 22.7bp, target: 30.0bp, stop: 17.0bp) on rising funding costs as the ECB continues QT. Risks are new ECB credit operations and an early end to QT. We remain biased for EUR FX-Sofr basis tightening on QT divergence between the Fed and the ECB. Tightening pressures may be further supported by global investors increasing purchases of euro assets on a FX-hedged basis using FX swaps.

  Supply - US

• The market is converging towards our expectations for higher deficits, which will lead to material supply growth in '26. We like 10s30s steepener & 30y spread short

Market likely moving to BofA baseline for deficits

While the current spending proposals by the House do not change our base case deficit forecasts, the market may be moving closer to our expectations for around 7% deficit in FY '26 & '27 ($2.2tn & $2.3tn, respectively). Market is likely realizing lower effective tariff revenues, limited scope of DOGE spending reductions and potential incremental tax cuts on top of TCJA extension support a higher deficit trajectory in both the medium and longer term. While there is still a high degree of uncertainty around what spending cuts could look like once the reconciliation bill gets to the Senate, we think market likely has greater conviction that material supply growth is coming in '26.

Supply is still a back-end trade (for now)

As discussed in US Macro we hold a 10s30s steepener and 30y spread short to position for continued cheapening pressure at the back end as the market grapples with more supply and the limited scope for back end demand (see: Flows report). We believe the back end will be the part of the curve that absorbs much of this risk as UST has yet to show responsiveness to this supply demand imbalance and market signals from term premium, spread curve shape, and 20y dislocation (see: Signal miss). While we are hopeful WAM UST/ TBAC discussion will be had in coming refunding meetings, we have limited conviction in what levels will garner enough concern for action.

Alternate deficit scenarios confirm coupon supply growth

In our base case, we assume UST grows coupons starting at the February refunding. We pushed this timing out from November given UST's forward guidance for stable coupons over "next several quarters." While we see a proactive UST as having room to grow sooner than Feb, deficit uncertainty will likely push coupon increases out to '26. In Exhibit 29 and Exhibit 30, we show bills as % of marketable debt assuming $280bn growth over four quarters starting in Feb '26 (similar to $300bn in four quarters observed in '23-'24) vs stable coupons. Even under a $200bn smaller deficit forecast, bills consistently breach 22% of marketable debt in FY '26 without auction size growth.

  Inflation - UK

•  The forward real yield between UKTi '35s and '49s is above 3% and above the US equivalent (making '49s costly borrowing for DMO). We would receive it versus US.

UKTi49s - cheap for investors, expensive for the borrower

In the Inflation Strategist two weeks ago, we argued that the DMO should syndicate UKTi 2035s next month (ignoring the near-universal consensus of investors and market makers suggesting UKTi 2049s). The forward real yield between the two bonds is above 3%, representing a punitive marginal cost of borrowing for the extra years, we argued.

Q4 International Investment Position (IIP) data saw the UK's net liabilities slashed by two thirds (thanks to back revisions), so UK linkers look much better value cross-market.

Putting those ideas together in Wednesday's Liquid Insight, we recommended receiving the forward yield between UKTi 2035s and '49s (via cash-for-cash extensions) and paying the equivalent in TIPS, for a pick-up of 22bp, setting a target of -40bp and a stop loss at 50bp (currently 16bp). Risk to the trade is poorly digested long-dated Gilt supply.

  Special Topic - US

• We see an upgrade of US expectations over the past month reflected in the: (1) fading negative momentum across macro factors; (2) cheapening of 10yT to fundamentals; (3) lower slowdown likelihood to c.65% from 80-85% in early April; (4) tightening of Equity Risk Premium by c.25bp; (5) slightly wide breakevens vs. fundamentals; and (6) an upgrade of risk appetite and allocations.

Rates models update

We update some of the rates models we use to gauge risk, positioning & RV across duration, curve, RYs, breakevens and front-end spreads. 10y nominal and RYs trade fair / marginally cheap to fundamental FVs as negative momentum in macro data fades. Breakevens continue to trade slightly wide as our inflation factor remains supported despite slowing activity suggesting higher stagflation fears. Funding pressure has remained sensitive to UST settlement dates despite TGA drawdown. Debt limit dynamics will likely help stabilize funding near-term but expect notable SOFR/FF basis tightening in the liquidity drain & bill supply post resolution. Metrics of portfolio risk bias suggest an upgrade of risk outlook from early Apr and a potential return to carry (short vol bias).

Duration and curve

10yT macro FV is c.4.25%, steady vs. early Apr. Relative to the global yield dynamic, we see c.4.35-4.4% FV, also steady from early Apr. Negative momentum in macro data faded over the past month (Broad macro -0.08σ, Inflation +0.24σ, Growth -0.54σ & Employment +0.16σ) and has contributed to a marginal cheapening of 10yT vs fundamentals.

Breakevens, TIPS and real yields

10y BEs trade slightly wide vs. FV (c.10-15bp) supported by stagflation fears, RYs trade fair. The likelihood of slowdown scenarios decreased over the last month from c.80-85% to c.65% currently.

Front end

We expect funding pressures to slow or even partially reverse in 1H25 due to debt limit dynamics. SOFR/FF basis is likely to tighten in 2H25, with SOFR rising faster than FF, driven by increasing marketable debt excluding Fed as a share of GDP, rising dealer holdings of USTs and declining liquidity. FF stickiness has been surprising but should see upward pressure in 2H25 as reserves continue to drain.

Allocations

Metrics of portfolio risk bias suggest an upgrade of risk outlook from early Apr (particularly in ETF flows) and a potential return to carry (short vol bias). Equity Risk Premium tightened c.25bp in the past month & remains historically tight.

Directional indicators

Expansion likelihoods priced in the 10y BEs dynamic normalized slightly to c.35% from c.15-20% in early Apr. We continue to see low expansion likelihoods priced in the dynamic of 10y BEs and EM credit vs 10yT yields (max c.35%), and marginally higher vs relative dynamic of IG Cash and IG/HY CDX vs. 10yT yields.

  Technicals

•  Upside risks for US yields continue to materialize. Multiple trend continuation patterns & MACD signals imply they still do. US2Y may be repeating Aug-Oct 2024 when it grinded up to 4.40%. US5Y yield is breaking above a trend line and 50wk SMA. US 10Y & 30Y yields show two uptrend continuation patterns. After a dip, we see the US 10s30s curve steepening to 55-65bps.
• For more, please see: Rates Technical Advantage: Deals for yields 14 May 2025

View: Deals for yields

Since Oct-2023 our view has been a cyclical bull market in US treasuries in 2024-2025, or a bias for lower yields. This bias has served us well. However, the last few months have been choppy and volatile due to macro policy expectations changing frequently and quickly. We last discussed upside yield risks. As yields have risen further with trade negotiations improving, we write again with more upside risks. To summarize, the daily chart of 2Y yield may be repeating the bottom formed in Aug-Oct 2024. The 5Y, 10Y and 30Y yields all formed uptrend continuation patterns. On the weekly charts of all tenors, we show the MACD indicator turning up in favor of higher yield trends persisting this summer with alternate wave count scenarios. We may see attractive levels by Memorial Day to consider buying, however, some of the signals in this report suggest patience for buy triggers this summer.

US 2Y Yield: 3.50-4.10% range. Aug-Oct 2024 repeat risk?

Trading rangebound between 3.50-4.10%. Short-term, we see similarity in the Mar-May 2025 period with that of Aug-Oct 2024. A break above the 200d SMA and trend line in the 4.08-4.10% area can trigger upside to 4.25% and 4.40%. Medium-term, the downtrend channel remains with yield resistance at about 4.20%. A weekly close above it increases upside risk to 4.42% and 4.75%.

US 5Y yield: Upside breakout above trend line, 50wk SMA

After forming a head and shoulders base in favor of upside, yield is breaking above a trend line and pursing wave C up to 4.20% and 4.35%. We see upside risks developing in the weekly chart, too, which can imply a rise to about 4.50%.

US10Y Yield: Two uptrend continuation patterns

Patterns in April-May imply upside risk for yield. This includes a wedge continuation pattern and a head and shoulders continuation pattern. A dip over the next few sessions as indicated by the TD Setup signal may precede a move higher to 4.59%, 4.66% and 4.72%. Ideally yield does not break above 4.80% for a cyclical bull market bias to remain. The weekly chart leaves us with many questions however the MACD turning up says yields can go higher with our most bearish scenario estimating a rise to 5.30%.

US30Y Yield: Uptrend continuation patterns, rising MACD

We see a wide trading range between 4.30-5.02% with upside risk due to two trend continuation patterns. The consolidation since the April peak formed a flag pattern and a head and shoulders pattern. Together they suggest upside potential to 5.02%, 5.17% and possibly 5.33%. If the move in 2023 repeats, there is risk that 30Y yield sees 5.50%.

US 10s30: Dip flatter then rip steeper

As the curve tactically flattens to support in the 35-40bps area and RSI mean reverts, we favor a steeper bias with upside to 55-65 basis points.

 Rates Alpha trade recommendations