The tariff announcements by the US administration on April 2nd and the subsequent escalation of tariff hikes between the US and China as well as the recent standoff between US President Trump and Fed Chair Powell have pushed US Treasury yields higher.1
Based on our econometric US Treasury model, we show the different channels through which we view policy could impact yields, notably inflation expectations, the budget deficit and foreign capital flows.
The biggest risk we see, however, would be a loss of confidence in government debt sustainability as well as in the Fed’s independence and commitment to low inflation.
Fed Treasury holdings depress the 10-year Treasury yield by nearly 200 basis points, based on our estimates. A confidence crisis could diminish that impact or, worse, turn it into the opposite if debt monetization is suddenly seen as inflationary by the market.
In our view, the recent rise in Treasury yields reflects mostly position adjustment, especially by leveraged investors, and is not yet a sign of an unfolding confidence crisis.
We also view business, household and financial sector balance sheet conditions as solid and unlikely to foster a financial crisis. However, the credibility of the government and the Fed as ultimate stability anchors in a crisis situation may no longer be assured.
Last year, we introduced our econometric macro model for 10-year Treasury yields and argued that yields are likely to stay higher for longer.2
The model separates nominal yields into inflation expectations and real yields, with the latter regressed on potential growth, inflation volatility, the government balance, domestic private net savings, foreign capital flows, the real Fed funds rate and Fed Treasury holdings.3
Building on this analysis, we divide the macro factors into three groups: 1) growth and inflation, 2) flow-of-funds and 3) Fed policy operations.
Chart 1 shows the contribution of the growth and inflation group to the 10-year US Treasury yield through the first quarter 2025; the contribution from real potential growth has been on a gradually upward moving trend since the financial crisis, while the contribution from inflation (expectations and volatility premium) spiked in 2022 and has since then declined but remains elevated.
Source: ZAIS estimates4
Until recently, we expected that the growth contribution would stabilize due to trends in demographics, and that the inflation contribution would decline further but not come back down to the lows seen between 2015 and 2021, with tighter labor market conditions and no more disinflation from deleveraging and globalization.
Now, we think that the growth contribution may moderate as the trade and immigration policies of the new administration undermine supply conditions.
On the other hand, we think the inflation component is unlikely to decline further and may rise again due to the inflationary impact of the government’s trade, immigration and fiscal policy agenda. Overall, we believe the balance of the growth and inflation contributions to Treasury yields is biased to the upside.
It is interesting to us that the estimates of the growth and inflation components alone imply 10-year Treasury yields of well above 5% for the first quarter of this year. In other words, the flow-of-funds and Fed components must have a depressing impact and offset part of the growth and inflation component.
Chart 2 shows the contributions from the government budget balance and domestic private net savings on the 10-year US Treasury yield. The yield-contribution of the government budget is positive given the persistence of deficits for more than 20 years.
The yield contribution of domestic private net savings is basically an inverse image of the government budget, which shows the government stepping in when private-sector savings rise in crisis periods as well as the crowding out effect of government deficit spending.
Source: ZAIS estimates5
Chart 3 completes the flow-of-funds impact on 10-year Treasury yields by adding foreign capital flows.
The contribution of government and private net savings together on Treasury yields is positive but more than offset by the impact of foreign capital inflows.
Source: ZAIS estimates6
In 2006, at the peak of the international reserve accumulation boom, the impact of foreign capital inflows on 10-year Treasury yields more than offset the impact of government and private net savings by 90 basis points.7 In the first quarter of 2025, that net impact had declined to 20 basis points.8
Until recently, our expectation was that the government deficit would stay high and potentially rise further, while we thought that domestic net private savings would decline due to higher investment needs and less savings related to demographics. We believed that foreign capital inflows would remain strong, but probably not enough to offset the yield-raising bias from government and private net savings.
Our outlook for the government deficit has not changed but we think that the domestic private sector will become more cautious and raise net savings due to increased policy uncertainty. On balance, that could be an improvement, but only if foreign capital inflows remain strong, which is questionable given the rise in policy uncertainty.
US financial markets have massively outperformed the rest of the world over the last few years9 and we think this has resulted in large overweight positions in US assets by international investors that apparently are now being rebalanced. However, whether this could lead to a structural de-dollarization is less clear to us as we see no obvious replacement to take the role of the USD.10
As we pointed out before, we believe yields would be well above 5% now based on the growth and inflation contributions. The flow-of-funds contribution closes that gap only marginally, which implies that the main yield depressing factor must be Fed policy. Chart 4 shows the contribution of the real Fed funds rate and Fed Treasury holdings to 10-year Treasury yields.
Source: ZAIS estimates11
The chart shows the contribution of the real Fed funds rate varies between positive and negative depending on the interest cycle and short-term inflation expectations but was still positive by about 40bps in the first quarter of this year. That leaves Fed Treasury holdings as the main yield-depressing factor.
Where Fed policy will go from here is much debated. The Fed’s current own projections imply a decline of the Fed funds rate by 50 basis points in 2025 and a continued gradual unwind of the Treasury holdings.12 The net impact of that could be a wash.
In our view, the Fed may soon end its unwinding of Treasury holdings, pointing to the need for a large balance sheet to maintain the Ample Reserve Regime.13 We also think the Fed remains more sensitive to negative unemployment surprises or systemic financial stress than persistent inflation pressures.
The table summarizes our outlook for the different 10-year Treasury yield components. On balance, we calculate that the trend points to higher 10-year US Treasury yields approaching 5% by the end of this year (see Chart 5). That would also imply a steeper curve based on our view that the Fed will probably ease by the end of the year.
Source: ZAIS outlook and estimates14
However, such model-based outlook projections require that the relationships observed in the past hold in the future. The risk is that a massive loss of confidence in US policy credibility could adversely change the relationships going forward.
Source: Board of Governors of the Federal Reserve System and ZAIS estimates15
In our view, a loss of confidence in US government debt sustainability as well as Fed independence and commitment to low inflation could trigger such a regime shift, with damaging implications for the US Treasury market.
We believe a deterioration of government debt sustainability would probably impact the parameters of the flow-of-funds component the most and raise the yield premium that investors require to hold government debt.
The budget reconciliation process in Congress is still ongoing but the government debt projections by the Committee for a Responsible Federal Budget suggest that debt sustainability is a serious concern.16
A loss of confidence in the Fed’s independence and commitment to low inflation would, in our view, primarily undermine the yield-depressing impact of Fed Treasury holdings.
In a worst-case scenario, when combined with a loss of confidence in government debt sustainability, monetization of government debt could be seen by the market as inflationary and reverse the impact of Fed Treasury holdings from yield depressing into yield compounding.
To be sure, we think the recent volatility in the Treasury market, although caused by policy uncertainty, which triggered position adjustments especially by leveraged investors, is not yet a sure sign of an inevitable confidence crisis. In contrast to prior stress situations, especially the financial crisis, we also view business, household and financial-sector balance sheet conditions as solid and unlikely to foster financial stress.
However, our analysis highlights the importance of policy credibility for the Treasury market. In particular, the credibility of the government and the Fed as ultimate stability anchors in a crisis situation may no longer be assured if the government and not the private sector becomes the source of financial instability.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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