US Treasury curve to steepen, sustained dollar weakness unlikely, and emerging-market FX remains overweight

Overview

The report covers US and international rates, foreign exchange, commodities, and emerging-market allocation. Its core view is that US inflation, term premium, and fiscal supply-demand dynamics will keep intermediate- and long-term US Treasury yields elevated, while the dollar's decline following the Treasury's expanded buybacks is more likely technical deleveraging. Meanwhile, energy and central-bank policy increase uncertainty in global rates, but the cyclical backdrop continues to support emerging-market FX.

Core views

On US rates, the report expects US real GDP to grow 2.0% year over year in the fourth quarter of 2026, core PCE inflation to remain at 3.5%, and unemployment to be broadly stable through 2026, reaching 4.1% in the fourth quarter. Given pressure on the credibility of the inflation mandate, the report expects the Federal Reserve to raise rates by 25 basis points in December 2026, lifting the federal funds target range from 3.50%-3.75% to 3.75%-4.00%. Its central-bank natural-language-processing model assesses every segment of the latest FOMC meeting as more hawkish than in June, particularly Chair Warsh's prepared remarks. The report argues that his doubts about the effectiveness of conventional rate hikes, emphasis on balance-sheet reduction tools, and de-emphasis of the 2% PCE inflation target could all raise inflation expectations and the term premium. This policy view implies a higher and steeper US Treasury yield curve. The report expects the 2-year, 5-year, 10-year, and 30-year US Treasury yields to end 2026 at 4.30%, 4.45%, 4.85%, and 5.40%, respectively, and expects these levels to persist through the first half of 2027. Relative to its previous forecast, front-end targets rise by only 5 to 10 basis points, while the 10-year target increases from 4.70% to 4.85% and the 30-year target from 5.20% to 5.40%. Front-end bonds still offer superior risk-adjusted carry, while the belly of the curve is expensive. Combined with higher medium-term inflation expectations and term premium, the report continues to express its view through a 2s/10s US Treasury steepener. The report views the Treasury's expansion of long-duration bond buybacks as a supply-composition event with limited impact. The cap per buyback operation for long-term nominal Treasuries will increase from $2 billion to “at least” $4 billion, effective September 9, and may continue beyond the current refunding quarter. The report finds no evidence that market functioning deteriorated enough to force the Treasury to expand buybacks; instead, it believes market functioning improved materially in 2026. The United Kingdom's 12 debt-management or budget announcements since November 2022 and Japan's five adjustments to long-term issuance since 2025 show that the effects of reducing long-end supply generally last only a few weeks, with diminishing marginal impact when repeated. Expanded buybacks are therefore insufficient to alter the direction of long-term yields determined by monetary policy and the term premium. Fiscal funding and investor demand further support elevated intermediate- and long-term yields. The report expects tariff refunds totaling $125 billion in FY26 and FY27; tariff revenue is projected at $325 billion in FY26 and to recover to $400 billion in FY27. The corresponding fiscal-deficit forecasts are $2.020 trillion and $1.960 trillion, respectively, versus forecasts of $1.955 trillion and $2.050 trillion at the start of the year. After deducting Federal Reserve purchases and buybacks, private-sector holdings of Treasury bills are expected to increase by $332 billion in calendar year 2026, while the private sector will absorb a net $1.305 trillion of coupon-bearing Treasuries. The Treasury's wording changed from “increase” future auction sizes to “adjust” them, making the risks appear more two-sided. However, the report expects a funding gap to emerge beginning in FY27 and widen significantly after FY28. It therefore delays its forecast for maintaining current auction sizes from February 2027 to August 2027, after which it expects 2-year through 10-year issuance sizes to rise over several quarters. The demand mix is also weak. Foreign investors are buying long-term US Treasuries at the slowest pace since 2021 and continue to shorten duration. US economic resilience, a more hawkish Federal Reserve, and more attractive valuations in investors' domestic government bonds suggest that foreign demand may remain weak. Commercial banks are reducing demand because of stronger loan growth and insufficiently attractive Treasury valuations, prompting the report to lower its demand forecast. Liability-driven investment demand also remains subdued because fixed-income allocations are already high, pension funding ratios exceed 100%, and their volatility has declined. Assets under management in core bond funds continue to grow rapidly, and yields near cyclical highs support inflows, but not enough to offset weakness elsewhere. The report estimates that other investors must absorb an additional $543 billion of US Treasury supply. The shift in ownership toward more price-sensitive investors will keep belly and long-end yields elevated through the remainder of the year. In international rates, developed-market yield curves have recently undergone broad bear steepening, with Japanese long-term government bonds performing particularly poorly. European natural-gas prices have risen to their highest level since the conflict began and, through global long-end rate linkages, have pushed up euro-area and UK yields. The report therefore remains cautious on European duration and disciplinedly stops out of its outright long position in 10-year German Bunds, while maintaining its high-conviction long position in 10-year German Bunds relative to 10-year US Treasuries. Within the euro area, the carry offered by current spread valuations is insufficient to withstand widening caused by risk aversion. The report maintains a short position in 10-year Italian bonds relative to France, an underweight in 10-year Belgian bonds relative to France and Germany, and a long position in 30-year EU bonds relative to swaps. UK duration remains neutral because US belly yields retain upside risk, although 30-year Gilts and the 15-year forward 15-year yield of 6.4% offer attractive valuations for long-term investors. In Sweden, the report believes markets are pricing in too much, with roughly 82 basis points of cumulative hikes by end-2027. Norway is still expected to deliver its final rate hike in September. In Japan, it maintains a short belly position in a 5s/10s/30s JGB butterfly and a 5s/20s steepener, while emphasizing cautious positioning. Curve and cross-market rate strategies are also retained in Australia and New Zealand. In foreign exchange, the Treasury's unexpected doubling of buybacks for 10-year to 30-year bonds triggered a rapid dollar decline, but the report attributes this to technical deleveraging rather than a lasting regime shift. It argues that “QE-like” or fiscal-currency-debasement narratives lack evidence of lost monetary control: inflation breakevens remain orderly, a developed-market fiscal basket has not outperformed, and the NLP hawkishness score for the July FOMC minutes was the highest in nearly two years. The historical analogy to the dollar decline triggered by the Treasury's 2023 refunding surprise does not fully apply in terms of event sequence, initial conditions, or scale. Long-dollar positions may face further pressure, but the report does not chase additional dollar downside. Even though joint US-Japan intervention and faster Bank of Japan rate hikes could limit upside in USD/JPY, the report still believes these measures are insufficient to prevent yen depreciation and retains confidence in global carry trades. In commodities, the largest oil-supply shock on record produced only roughly average price outcomes because inventory declines were far smaller than expected while demand destruction was much greater than expected, creating a powerful offset. The report forecasts annual average WTI prices of $80/bbl in 2026 and $59/bbl in 2027, and Brent prices of $86/bbl and $63/bbl, respectively. The key near-term variable for natural gas is the continued disruption of shipping through the Strait of Hormuz. Qatar could approach storage capacity in the coming weeks and may then be forced to shut down or sharply reduce liquefaction capacity; the restart process could delay the recovery of supply until the Northern Hemisphere winter. The report forecasts annual average European TTF gas prices of €50/MWh in 2026 and €46/MWh in 2027. Aggregate agricultural positioning remained moderate as of August 11, but soft-commodity positioning rose to a six-month high, driven mainly by ICE raw sugar shifting from net short to net long. The forecast table also shows annual average copper prices edging down from $13,869/tonne in 2026 to $13,800/tonne in 2027, while gold rises from $4,545/oz to $4,775/oz. In emerging markets, the two principal risks—energy prices and Federal Reserve policy—keep uncertainty elevated and investor positioning light. The report nevertheless maintains an overweight in emerging-market FX because of a supportive cyclical outlook, while keeping emerging-market rates neutral to reflect increasingly two-sided inflation and central-bank-policy risks. Emerging-market sovereign and corporate credit are also neutral because tight valuations offset otherwise constructive fundamental factors. In the GBI-EM model portfolio, country positions in bonds and FX contributed 23 and 29 basis points year to date, respectively, with overlays bringing the final portfolio contribution to 56 basis points. The EMBIGD model portfolio remains neutral; its year-to-date return is 2.7%, versus a benchmark return of 2.3%, representing 40 basis points of outperformance.

Analysis framework

The report first derives the Federal Reserve path from growth, inflation, unemployment, and FOMC communications, then decomposes policy expectations into the effects of front-end rates, inflation expectations, and term premium on the yield curve. It subsequently estimates the supply-demand gap by combining fiscal deficits, Treasury issuance, buyback arrangements, and demand from different investor groups. The international-markets section uses cross-market yields, forward OIS, and relative-valuation comparisons. The foreign-exchange section combines pre- and post-event prices, positioning, and macroeconomic evidence to assess whether dollar weakness is sustainable. The commodities and emerging-markets sections derive allocation views from supply-demand shocks, positioning, valuation, and model-portfolio risk budgets.

Methodology notes

• Fixed-Income and Credit AnalysisYield curve analysis

  Yield-Curve and Term-Premium Analysis

  The report compares the policy sensitivity, valuation, and carry of front-end, belly, and long-end bonds, using inflation expectations and the term premium to explain why the US 2s/10s curve may steepen.

• Fixed-Income and Credit Analysis

  Risk-Adjusted Three-Month Carry and Roll-Down Return

  The report divides three-month carry and roll-down returns by the standard deviation of daily yield changes over the same period to compare the return attractiveness of US Treasuries across maturities after adjusting for similar levels of risk.

• Quantitative/Factor/Portfolio TheoryMulti-factor model

  Regression Attribution of Changes in the 30-Year US Treasury Yield

  The report explains changes in the 30-year yield using short-term OIS, a US rate-risk indicator, long-term inflation breakevens, the Federal Reserve balance sheet as a share of the economy, and a tariff dummy variable. The historical regression has an R² of 97.9% and a standard error of 16 basis points.

• Quantitative/Factor/Portfolio Theory

  Central-Bank Communication Natural-Language-Processing Model

  The report uses natural-language processing to assess the hawkish or dovish tone and policy relevance of FOMC statements, prepared remarks, Q&A sessions, and minutes, helping determine whether the policy stance has turned more hawkish than at the previous meeting.

• Event-Based Game Theory and Behavioral FinanceEvent-driven analysis

  Event Comparison of Treasury Buybacks and Issuance Adjustments

  The report compares the current US long-term Treasury buybacks with the 2023 US refunding surprise and market reactions following long-term issuance adjustments in the United Kingdom and Japan to assess the duration and diminishing impact of changes in supply composition.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• US Treasuries

  The report expects intermediate- and long-term yields to remain elevated and maintains a 2s/10s curve steepener.

  Strengths

  The front end offers superior risk-adjusted carry, while core bond funds continue to see strong inflows.

  Weaknesses

  The belly of the curve is expensive, and demand from foreign investors, commercial banks, and liability-driven investors is weakening.

  Comparison

  The report expects the 2-year and 10-year yields to reach 4.30% and 4.85%, respectively, by end-2026.

  Risks

  A coordinated rebuttal of the Chair's remarks by FOMC members could weaken the bear-steepening move.

• Euro-Area Government Bonds

  The report reduces outright duration risk but retains a long position in 10-year German Bunds relative to US Treasuries and a long position in 30-year EU bonds relative to swaps.

  Strengths

  Some yields are near their highest levels since the conflict began, and the cross-market valuation of Germany relative to the United States remains attractive.

  Weaknesses

  Natural-gas prices, geopolitical uncertainty, and tight spreads provide insufficient carry protection.

  Comparison

  The report shorts 10-year Italian bonds relative to France and underweights 10-year Belgian bonds relative to France and Germany.

  Risks

  Risk aversion could widen intra-euro-area and euro SSA spreads.

• UK Government Bonds

  The report maintains neutral duration while viewing ultra-long maturities as attractively valued.

  Strengths

  The 30-year cash bond and 15-year forward 15-year yield of 6.4% are relatively attractive to long-term investors.

  Weaknesses

  Rising energy prices and further increases in US belly yields could weigh on UK government bonds.

  Comparison

  The report continues to receive September 2026 MPC OIS, believing the hurdle for a September rate hike is high.

  Risks

  The Middle East conflict and low European natural-gas inventories ahead of winter could intensify rate volatility.

• US Dollar

  The report views the dollar's decline after the Treasury expanded buybacks as primarily technical deleveraging rather than a lasting weak-dollar regime shift.

  Strengths

  Inflation breakevens are stable, the fiscal-currency basket has not outperformed, and the FOMC minutes are hawkish.

  Weaknesses

  Long-dollar positioning remains vulnerable to further pressure.

  Comparison

  The current event differs materially from the 2023 refunding surprise in sequence, initial conditions, and scale.

  Risks

  If fiscal policy ultimately evolves into fiscal dominance without monetary restraint, the current view would be challenged, although the report says there is no empirical support for this at present.

• Japanese Yen

  Joint intervention may constrain upside in USD/JPY, but the report retains its view of a weaker yen.

  Strengths

  Joint intervention and faster Bank of Japan rate hikes could reduce one-way volatility.

  Weaknesses

  The report believes these measures remain insufficient to reverse the yen's depreciation trend.

  Comparison

  The yen view is consistent with the report's continued confidence in global carry trades.

  Risks

  Stronger or more sustained policy intervention could alter the existing trajectory.

• Crude Oil and Natural Gas

  Weaker demand offsets the oil-supply shock, while natural gas faces constraints from Qatari storage and shipping through the Strait of Hormuz.

  Strengths

  The oil-supply shock did not translate into exceptionally high prices, showing that weaker demand provides a buffer.

  Weaknesses

  If Qatar is forced to reduce liquefaction capacity, the recovery of supply could be delayed until the Northern Hemisphere winter.

  Comparison

  The annual average WTI forecast declines from $80/bbl in 2026 to $59/bbl in 2027, while Brent declines from $86/bbl to $63/bbl.

  Risks

  A prolonged disruption in the Strait of Hormuz and escalation of the Middle East conflict could increase natural-gas prices and European rate risks.

• Emerging-Market FX

  The cyclical outlook supports the report's continued overweight.

  Strengths

  The report believes the macroeconomic cycle remains supportive.

  Weaknesses

  Energy prices and Federal Reserve policy keep uncertainty elevated.

  Comparison

  By contrast, emerging-market rates, sovereign credit, and corporate credit are all only neutral.

  Risks

  Inflation and central-bank-policy risks are becoming increasingly two-sided.

• Emerging-Market Rates and Credit

  The report maintains neutral weights in emerging-market rates, sovereign credit, and corporate credit.

  Strengths

  The overall backdrop excluding valuations remains constructive, and the EMBIGD model portfolio has outperformed its benchmark by 40 basis points year to date.

  Weaknesses

  Credit valuations are tight, while rates face two-sided inflation and central-bank-policy risks.

  Comparison

  The allocation conviction is lower than the overweight in emerging-market FX.

  Risks

  Spread widening and energy shocks could erode the limited buffer provided by tight valuations.

Key data

• 2026 US GDP Growth2.0%Year-over-year forecast for the fourth quarter of 2026
• 2026 Core PCE Inflation3.5%Year-over-year forecast for the fourth quarter of 2026
• Fourth-Quarter 2026 Unemployment Rate4.1%The report expects it to remain broadly stable throughout the year
• Federal Reserve Policy Forecast25-basis-point rate hike in December 2026Target range rises to 3.75%-4.00%
• End-2026 2-Year US Treasury Yield4.30%Expected to persist through the first half of 2027
• End-2026 10-Year US Treasury Yield4.85%Previous forecast was 4.70%
• End-2026 30-Year US Treasury Yield5.40%Previous forecast was 5.20%
• Size per Long-Term US Treasury BuybackIncreased from $2 billion to at least $4 billionEffective September 9
• FY26 Fiscal-Deficit Forecast$2.020 trillionForecast at the start of the year was $1.955 trillion
• FY27 Fiscal-Deficit Forecast$1.960 trillionForecast at the start of the year was $2.050 trillion
• Net Private-Sector Absorption of Coupon-Bearing US Treasuries$1.305 trillionCalendar-year 2026 forecast, net of Federal Reserve purchases and buybacks
• Required Absorption of Additional US Treasury Supply$543 billionMust be absorbed by other, more price-sensitive investors
• UK 15-Year Forward 15-Year Government-Bond Yield6.4%The report considers it attractively valued for long-term investors
• Year-to-Date GBI-EM Model-Portfolio Contribution+56 basis pointsCountry positions in bonds and FX contributed 23 and 29 basis points, respectively
• Year-to-Date EMBIGD Model-Portfolio Return2.7%The benchmark returned 2.3%, representing 40 basis points of outperformance

Impact & implications

The report argues that elevated US inflation, hawkish policy risks, a rising term premium, and the shift in Treasury demand toward price-sensitive investors will limit downside in intermediate- and long-term US Treasury yields, making curve steepening more consistent with its base case than an outright long-duration position. Expanded Treasury buybacks may affect the dollar and long-end bonds in the short term but are insufficient to constitute quantitative easing or a mechanism for sustained depreciation. European energy and geopolitical risks require restraint in outright duration, while within emerging markets investors should distinguish between cyclically supported FX and tightly valued rates and credit assets.

Risks

• Energy prices and Federal Reserve policy are the two key risks identified in the report; both keep uncertainty elevated and investor positioning light.
• If FOMC members collectively rebut the Chair's remarks on policy tools and the inflation target, the extent of the bear steepening in US Treasuries may be constrained.
• The Middle East conflict, elevated European natural-gas prices, and low inventories ahead of winter could continue to push up European yields and market volatility.
• If shipping disruptions through the Strait of Hormuz persist, Qatar may be forced to shut down or sharply reduce liquefaction capacity, potentially delaying the recovery of supply until the Northern Hemisphere winter.
• Tight valuations in intra-euro-area bonds and emerging-market credit provide limited protection against deteriorating risk sentiment and spread widening.

What to watch

• Watch whether the Federal Reserve raises rates by 25 basis points in December 2026 as forecast and whether other FOMC members rebut the Chair's policy remarks.
• Track whether the 10-year and 30-year US Treasury yields approach 4.85% and 5.40%, respectively, by end-2026.
• Observe whether the doubling of long-term Treasury buybacks effective September 9 continues beyond the current refunding quarter.
• Watch whether the Treasury maintains current auction sizes through August 2027 and subsequently increases issuance of 2-year through 10-year Treasuries.
• Track the actual absorption of new Treasury supply by foreign investors, commercial banks, bond funds, and liability-driven investors.
• Monitor shipping through the Strait of Hormuz, Qatari storage levels, and whether liquefaction capacity is shut down or materially reduced.
• Watch European natural-gas prices, developments in the Middle East conflict, and the transmission of winter inventories to European and UK rates.
• Track whether cyclical support for emerging-market FX can offset risks from energy, inflation, and Federal Reserve policy.