incoming data suggest that the Fed faces little hurdles in moving the policy rate towards neutral. Labor market risks remain squarely to the downside and underlying inflation is contained. Meanwhile, consensus forecasts for budget deficits and term premium are still high. We remain long duration.
We maintain our recommendation to be long 5y5y USTs (entry: 4.91%; current: 4.52%; notional neutral long in 10y USTs vs. 5y USTs). 5y5y real rates embed a significant term premium, and 5y5y swap spreads have already discounted larger deficits than is warranted. Rising tariff revenues and falling short rates should assuage concerns about the US fiscal profile.
We maintain our recommendation to pay the belly of the 1yf 2s5s10s fly (entry, -18bp current-16bp). With the easing cycle likely over within 12 months, the fly should not be negative. If the markets are a putting fiscal risk premium in 5y5y, they should put some hike premium in the 1yf 2s5s curve as well.
We maintain our recommendation to be long the belly of the 1:2:1 10s20s30s Treasury fly (entry: 57bp, current 55bp), as the 20y sector continues to look cheap on the curve, given the decline in volatility. We switch to using current on-the-runs in the trade.
We maintain 10s30s spread curve flatteners (entry: -30bp, current -30bp) as there is limited scope for meaningful steepening given the fiscal outlook and buyback announcement behind us.
We remain constructive on front-to-belly swap spreads and maintain our 5y spread widener recommendation (entry: -38.5bp; current: -36bp), which is less sensitive to near-term repopressures as the Treasury rebuilds its cash balance.
We maintain a 2y10y vs. 6m10y low-strike calendar spread to position for lower rates and underpriced intermediate vol. We maintain a 1y1y low-strike 1:1.25 receiver spread if Fed chair uncertainty falls and the market subsequently prices more dovish policy. We maintain buying 2y*1y straddles, given that left-handside vol is cheap, considering the uncertain backdrop.
On the move: Incoming data suggest the economy has downshifted, whether one looks at GDP growth, payroll gains or measures of slack. Inflation data have also been softer than expected; underlying inflation and expectations point to inflation reverting to close to target next year. In that context, the Fed is likely to be more concerned about downside risks to the labor market than inflation persistence and signal a gradual move towards neutral at the upcoming meeting.
Is the fiscal improvement already discounted? We do not think so. Much ink has been spilled about the fiscal profile, in the US and globally, but with long-term yields moving lower in the US over the past few months, both outright and relative to other countries, one might wonder if the positive fiscal news (higher tariff revenues) is fully in the price. We do not think so and believe markets are too concerned about deficits.
First, most still expect budget deficits to remain wide, which is inconsistent with tariff revenues and falling interest rates. We estimate that the primary deficit is likely to be about 2.6% of GDP in each year, slightly smaller than the 3% in 2025. Interest costs are likely to be about 3.2%. With the coupon on the existing forward notes/bonds universe about 3%, new issuance yield of 3.6% and bill yields expected to fall to about 3%, interest expense should be contained. This implies a total budget deficit in 2026 and 2027 a bit below 6%, roughly 0.5pp smaller than the consensus.
One feature of a shorter WAM of the outstanding universe and gross issuance is that a significant portion of debt can re-strike into lower yields when they fall along with Fed cuts. The flip side is when the Fed hikes and yields rise, but that is not the current backdrop.
As the consensus revises its forecasts lower, long-end swap spreads and Tsy yields should fall. Markets are likely hair-cutting tariff revenues. One possibility is that they are putting some weight on the administration's not being able to raise tariff revenues persistently. We believe that even if the Supreme Court rules against the administration on the legality of IEEP tariffs, other legal authorities could achieve a similar trade policy outcome. Hence, the revenue stream will remain intact. Any one time refunds would be paid for by raising bill issuance. Another is that markets are pricing in some chance that a new fiscal stimulus will be passed, funded by the existing tariff revenues. A new reconciliation bill would certainly change the calculus, but it does not appear there is a major push towards that.
Second, fundamental drivers are arguing for a lower rate term premium. Lower vol should lead to a lower term premium as investors get more comfortable terming out the curve. Barring a few exceptions, this is at the lows. Another factor that supports a low term premium is inflation breakevens. 5y5y CPI swaps are trading at 2.5%, not far from the recent run-rate and well below pre-GFC averages. For all the talk about Fed independence, markets continue to view inflation as returning towards the target, with little risk premium for upside risks. If investors are not demanding a high inflation risk premium, why should they demand a high nominal term premium?
The Fed has been shrinking its balance sheet, but it is likely to stabilize a bit above 20%, which is well above pre-GFC averages of 5% GDP. Putting this together suggests that the rate term premium should be low. A similar exercise suggests that in 5yf 5y, the rate term premium should be 35-40bp and 5y5y OIS should be 3.5%, versus the current 3.75%. Hence, 5y5y UST yields can fall due to lower swap rates and wider swap spreads. While they have moved 50bp lower from the recent highs, they still look high.
Nothing to fear
Incoming data suggest that the Fed faces little hurdles inmoving the policy rate towards neutral. Labor market risksremain squarely to the downside and underlying inflation iscontained. Meanwhile, consensus forecasts for budgetdeficits and term premium are still high. We remain longduration.
Anshul Pradhan+1 212 412 3681anshul.pradhan@barclays.comBCI, US
Demi Hu, CFA+1 212 526 7398demi.hu@barclays.comBCI, US
The long end of the US Treasury market has again outperformed this week, with the curve bullflattening . Figure 1 shows that 2y yields were unchanged since Friday's close amidsoftinflationdata and 30y have fallen almost 10bp. Figure 2 shows thatover the past three months, US 30yhas rallied about 25bp, while the core European long end has soldoffabout 30bp, led byFrance, where an increase in political uncertainty has led to questions about its ability to fiscallyconsolidate (see here). The long end has soldoffin the UK and Japan as well, where similarquestions prevail, with elections in Japan potentially creating a range of outcomes (see here). Incontrast, in the US, investors are coming around to the fiscal improvement that is underway.Risk assets were up over the week, as the markets see the Fed having room to cut to stabilizethe economy if needed.
Eveline Dong+1 212 526 9576eveline.dong@barclays.comBCI, US
We have been recommending being long duration (via 5y5y USTs, entry 4.91%, current4.52%),given our views that markets are too optimistic about growth expectations and at thesame time have not fully reflected the fiscal improvement. We maintain the long duration view,as the market pricing of the path of the policy rate should still move lower, along with the termpremium.
We believe the modal terminal rate expectations should move down as the market reassessesthe neutral rate, as well as the balance of risk, with higher likelihood of a more aggressivecutting cycle, as opposed to a shallower one. Contained forward inflation and ongoingweakening of the labor market argue for a further repricing.The Fed is likely to revise its dotsmaterially lower at the next week's FOMC meeting.
Separately, markets have not yet fully internalized the fiscal improvement. Even if the SupremeCourt rules against the administration and the Treasury has to refundtariffscollected so far, therevenue stream is unlikely to beaffected,as the administration can rely on other legalauthorities. If needed, it is also likely to rely on expanding the T-bill universe for one-timerefunds;long-end coupon size increases are not on the table, in our view, for at least thenext couple of years. Separately, the markets are under-appreciating the advantage of having arelatively short WAM on interest expenses in a cutting cycle. Budget deficits are likely toundershoot the consensus expectation of 6.5% GDP.
Thisdocument is intended for institutional investors and is not subject to all of theindependence and disclosure standards applicable to debt research reports prepared for retailinvestors under U.S. FINRA Rule 2242. Barclays trades the securities covered in this report for itsown account and on a discretionary basis on behalf of certain clients. Such trading interestsmay be contrary to the recommendationsofferedin this report.
Please see analyst certifications and important disclosures beginning on page 9.Completed: 11-Sep-25, 19:01 GMTReleased: 11-Sep-25, 21:20 GMTRestricted - External
We therefore continue to recommend being long duration.
FOMC: On the move
Incoming data suggest the economy hasdownshifted,whether one looks at GDP growth,payroll gains or measures of slack. Inflation data have also beensofterthan expected;underlying inflation and expectations point to inflation reverting to close to target next year. Inthat context, the Fed is likely to be more concerned about downside risks to the labor marketthan inflation persistence and signal a gradual move towards neutral at the upcoming meeting.
Figure 3 shows the evolution of quarterly real GDP growth rates. The US economy is expected togrow at about 1.5% in 2025 up to Q3, as opposed to 2.5% in 2024. Private domestic final sales(excluding inventory, net exports and the government sector) paint a story of a sustainedshiftlower from about 2.5pp to 1.5pp (in contribution terms). Forward-looking measures are notpointing to a material rebound. For one, the payroll proxy (product of employment * hours *earnings) has slowed dramatically. It grew at just 0.3% in nominal terms in August and likelyclose to nil in real terms (Figure 4). Income growth barely keeping up with inflation does notbode well for the personal consumption outlook.Tariffuncertainty should eventually subside,but into an outcome far worse than was expected earlier in the year.
As for labor markets, the latest data, along with potential benchmark revisions, also point to jobgains having moderated dramatically. Figure 5 shows that over the past three, six and 12months, job gains have averaged 30K,