The "Political Account" of U.S. Treasury Bonds

The performance of the U.S. Treasury market this year has indeed exceeded market expectations. On one hand, at the beginning of the year, the market anticipated that the impact of Trump's policies would lead to another year of a bond bear market, yet this year, U.S. Treasuries (represented by the 10-year yield, on an annual basis, as of December 3) have yielded the highest returns in nearly five years; on the other hand, as one of the major global pricing benchmark markets, volatility has continuously decreased following the tariff shocks. Compared to the significant volatility of gold, U.S. stocks, and some cryptocurrencies, the price fluctuations of U.S. Treasuries have been relatively mild.

Why has this year's performance been like this? We summarize it into three "surprises":

The first is that the combination of growth and inflation leans more towards "stagflation" rather than purely "inflation." If one word could summarize the U.S. economy in 2025, "stagflation" is one of the unavoidable main themes. However, due to the inherent fragility of the U.S. economy, policies such as tariffs and immigration have not brought about significant inflationary pressures; instead, they have led to a rapid decline in employment and confidence. The pressure from economic downturn has outweighed inflation, resulting in U.S. Treasury yields (as of the end of October) showing an overall downward trend for most of the year, except for brief upticks in May and July when economic data was temporarily strong.

The second is that the U.S. fiscal expansion has been relatively restrained. After all, "market-oriented" Secretary of the Treasury Janet Yellen may be more concerned about long-term interest rates in recent years. The restrained fiscal measures are reflected in the overall decrease in the U.S. government fiscal deficit compared to last year, and can also be seen in the details of the tax reduction legislation. The "Great American Rescue Plan," passed in July this year, includes many income tax reduction clauses that take effect this year, but the Treasury has chosen not to modify tax rates for now, opting to return taxes to residents at the new rates early next year.

Yellen's concern about long-term interest rates has gradually become a market consensus. Besides public statements, the most typical example is the intentional preference for short-term Treasury bonds in this year's Treasury issuance (to avoid rising long-term interest rates). As of October, short-term Treasury bonds accounted for about 22% of the tradable Treasury bonds, which is not common under normal economic conditions.

The third is that foreign capital has not "given up" on U.S. Treasuries; instead, it has increased its holdings significantly. In the second quarter of this year, there were concerns in the market that, under the uncertainty of tariffs and other policies, foreign capital might reduce its holdings of U.S. Treasuries. However, the actual situation is quite different: from a horizontal perspective, foreign capital remains the largest sector increasing its holdings of U.S. Treasuries; from within foreign capital, official institutions have limited increases, while private institutions have increased their holdings significantly, adding $535.4 billion in the first three quarters, most of which are medium- to long-term U.S. Treasuries The underlying logic, aside from conventional arbitrage and diversified allocation, is that this year the bond markets in Europe and Japan have experienced greater volatility. From the perspective of relative returns and risk aversion, the attractiveness of U.S. Treasuries for some foreign investors has increased.

So, looking towards 2026, can the U.S. Treasury market maintain its low volatility characteristics?

We believe it is unlikely, and the main issue lies not in the economy but in politics—the economic policies in an election year in the U.S. may become more proactive.

How will policies be implemented? The key is to look at public opinion. According to polls, the greatest dissatisfaction with Trump's presidency remains inflation, while the area with the largest decline in approval since taking office is economic issues. We believe that the recently highlighted "Affordability Crisis" is at the forefront. Solving this issue mainly involves two approaches: one is to lower commodity prices, and the other is to increase household income. We anticipate a "two-step" approach:

The first step is to take measures to control inflation, coupled with promises of "verbal checks" to salvage public opinion. A typical example of the former is the decisive cancellation on November 20 by the White House of the 40% additional tariffs on Brazilian imports of beef, coffee, and other agricultural products, as Brazil is an important source of these goods for the U.S. The latter includes instances where the Trump administration has publicly stated multiple times that it intends to issue $2,000 "red envelopes" in tariffs to eligible American residents.

The second step is to monitor the trend of public opinion. If public sentiment rebounds, then fiscal and monetary policies may be more objective, and the new Federal Reserve Chair can emphasize independence, with interest rate cuts not exceeding 75 basis points; if public sentiment does not improve, then fiscal and monetary policies may be intensified, with interest rate cuts exceeding 100 basis points. Based on different combinations of fiscal and monetary policies, we analyze the changes in the center of the 10-year U.S. Treasury yield by dividing it into short-term rates (reflecting policy) and term spreads (reflecting market trading and expectations):

If significant progress is made in the first step and public sentiment improves, then next year monetary and fiscal policies will remain appropriately accommodative. Monetary policy will cut rates by 75 basis points, and fiscal policy will mainly focus on implementing tax reduction measures, leading to a moderate economic recovery, with inflation peaking and declining. The central yield of the 10-year U.S. Treasury is expected to gradually decrease from the current level of around 4.1% to about 3.8%.

Conversely, if the first step proves ineffective, the White House may have to adopt more aggressive policies to salvage public sentiment, including interest rate cuts exceeding 100 basis points and providing more fiscal subsidies to residents. We have calculated an extreme scenario where, in addition to tax cuts, the Trump administration fulfills its promise of "red envelopes," and the Supreme Court also requires the refund of this year's "reciprocal" and "fentanyl" tariffs According to our calculations, the federal government's deficit rate may exceed 8% in 2026. In this case, the increase in the yield spread is likely to be significantly greater than the rate cuts at the short end, leading to a potential rise in the 10-year U.S. Treasury yield above 4.7%.

In this scenario, the Federal Reserve may consider initiating measures similar to QE to purchase long-term bonds to stabilize long-term rates. Based on this year's experience, a 10-year yield above 4.6% may make investors uncomfortable, at which point market opportunities driven by corresponding policies can be monitored (establishing long positions based on Federal Reserve policy adjustments).

In the other two scenarios, the range and volatility of the 10-year U.S. Treasury yield may be relatively smaller. A more aggressive fiscal policy combined with a cautious monetary policy (rate cuts within 50bp) may lead to a slight increase in the 10-year yield center to around 4.4%; alternatively, if fiscal policy remains moderate and monetary policy is more accommodative, such short-end declines are unlikely to fully transmit to the long end in the absence of an economic recession, resulting in long-term rates potentially experiencing wide fluctuations.

In summary, we believe that with clearer policy guidance, the volatility in the U.S. Treasury market will be greater in 2026. After all, under institutional constraints such as electoral politics, some Western countries often find it more challenging to fully prioritize long-term goals over short-term economic demands in the medium to long term.

Risk Warning and Disclaimer

The market carries risks, and investment should be approached with caution. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article align with their specific circumstances. Investment based on this is at one's own risk