Contrarian Fixed Income Play: Why US Treasuries and the Dollar Are Bullish Amid Fiscal Risks

The U.S. fiscal deficit is projected to hit $1.9 trillion in 2025, with debt-to-GDP ratios soaring to 123%, yet this environment presents a contrarian opportunity in fixed income. Softening services inflation, fading tariff threats, and Europe's relative fiscal discipline are creating a tactical bullish case for U.S. Treasuries and dollar-denominated assets. Here's why investors should consider this counterintuitive strategy.

The Case for U.S. Treasuries: Inflation's Hidden Moderation

While headline inflation remains above the Fed's 2% target, the underlying dynamics are shifting. The May 2025 services CPI showed a 0.2% monthly increase, with the 12-month rate holding at 2.8%. This stability is driven by the shelter component, which rose just 0.3% in May. Despite lingering at 3.9% year-over-year, housing costs are now in a “lagged moderation phase,” as noted in the Fed's June report. Unlike earlier surges in rent, recent market rents have stabilized near pre-pandemic levels, suggesting further deceleration ahead.

This softening supports the Fed's patient stance. Even as the deficit balloons, the central bank can delay aggressive rate hikes because inflation is no longer accelerating.

Fading Tariff Threats: A Tailwind for Bond Markets

Geopolitical tensions remain, but the risks of a full-blown trade war are overblown. The Fed's baseline scenario assumes tariffs remain at 15%, with China facing 50% levies. However, the probability of a negotiated resolution is rising. For instance, recent talks to ease restrictions on Chinese tech imports could reduce near-term inflation pressures.

Crucially, the University of Michigan's short-term inflation expectations—which spiked to 5.1% in June—include tariff-driven fears that may not materialize. If trade tensions ease, as the upside scenario suggests, bond yields could drop sharply.

Europe's Fiscal Discipline: A Dollar Tailwind

While the U.S. grapples with deficits, the Eurozone's fiscal restraint is often overlooked. The IMF projects the euro area deficit at 3.3% in 2025, versus 5.5% for the U.S. by 2030. Germany's debt-to-GDP is projected to stay below 75%, while France's 128.4% is still lower than the U.S. 123%—a stark contrast to popular perception.

This fiscal prudence supports the EUR/USD parity, but the dollar's resilience is bolstered by two factors:

1. Interest Rate Differentials: The Fed's neutral stance keeps U.S. yields higher than the ECB's near-zero rates.
2. Flight-to-Quality: Despite its deficits, the U.S. remains the world's deepest bond market. Europe's energy and geopolitical vulnerabilities (e.g., Israel-Iran tensions) reinforce demand for dollar assets.

Investment Strategy: Long Treasuries, Short EUR

• Fixed Income: Overweight 10-year Treasury notes. The lagged moderation in shelter inflation and fading tariff risks suggest yields could fall to 4.0% by year-end, from their current 4.5%.
• Currency Play: Short EUR/USD pairs. Europe's fiscal discipline vs. U.S. deficits and interest rate differentials favor the dollar.
• Dollar-Denominated Assets: Consider emerging-market debt in USD or European equities with dollar exposure, hedged against EUR weakness.

Risks and Caveats

• Deficit Expansion: If the Fed panics over deficits and hikes rates, yields could rise. However, the CBO projects net interest costs to grow only 12% by 2027, manageable without austerity.
• Tariff Escalation: A downside scenario with 25% tariffs would trigger recession risks, but this is unlikely given political pragmatism.

Conclusion: A Contrarian Win

The market is fixated on U.S. deficits and fiscal risks, but the data tells a different story. Services inflation is stabilizing, trade tensions are manageable, and Europe's fiscal discipline is underappreciated. For contrarians, this is a rare moment to buy U.S. Treasuries and go long the dollar—a bet that plays to both macro stability and mispriced expectations.