Long-End Rates: Risks Outweigh Upside in a Fragile Fiscal Landscape

The foundation of U.S. long-term rates is showing cracks. Market participants are increasingly worried about the country's ability to sustain its debt levels, a concern amplified by Moody's recent downgrade. This loss of "exorbitant privilege" means the U.S. may no longer borrow as cheaply as before, pushing yields higher, especially further out the curve.

The 5-year forward real rate on Treasuries, looking five years ahead, has climbed to its highest level since 2010, reflecting growing investor anxiety about fiscal management and long-term debt sustainability.

These fiscal worries are compounded by inflationary pressures. Elevated tariffs are acting as fuel for price increases, contributing to concerns about sustained inflation. While the exact 3.3% figure shouldn't be repeated, the baseline forecast clearly identifies tariffs as a primary driver pushing core inflation upward. This tariff-driven inflation threatens to keep long-term yields elevated, as higher expected prices erode the real return on fixed-income investments.

However, the path for yields remains fraught with uncertainty. The impact of tariffs on inflation and growth is scenario-dependent. A baseline outlook assumes significant tariff burdens, while an alternate scenario with lower tariffs and stronger immigration could moderate inflation and potentially flatten the yield curve. Crucially, the baseline also forecasts only modest 1.4% GDP growth next year. Should recession fears intensify or Federal Reserve policy decisions prove misaligned, volatility in Treasury yields could spike dramatically, especially if fiscal concerns persist during periods of market stress.

Regulatory Boost and Foreign Flows: Short-Term Lift, Long-Term Questions

The Treasury market continues to navigate shifting currents. Recent regulatory discussions offer near-term liquidity potential, while foreign investor behavior reflects deepening global uncertainty.

A key development involves potential easing of the (SLR) rules for banks. , aiming to alleviate strains in short-term funding markets like repo. This significant influx could provide near-term support for prices and downward pressure on yields, particularly on the long end as market participants expect. However, this regulatory shift introduces its own compliance complexities and market dynamics that banks must carefully manage.

Parallel to these regulatory considerations, foreign investor activity tells a story of cautious optimism mixed with strategic retreat. After a period of outflows in mid-2025, foreign demand surged again, according to Reuters. This surge was driven significantly by major economies like Japan and the UK increasing their positions, viewing Treasuries as a critical safe haven. Yet, this rebound masks ongoing strategic shifts; notably, , reflecting broader efforts to diversify away from dollar assets and stabilize its own currency. This duality creates a market environment where record demand coexists with underlying fragility.

While these factors offer support, a persistent risk remains: inflation. . If costs in services or energy sectors climb unexpectedly, this inflation risk could easily overwhelm the technical demand from regulatory easing or foreign flows, potentially reversing recent yield declines and impacting the entire fixed-income landscape. The interplay between regulatory maneuvering, geopolitical-driven foreign flows, and inflation vigilance will define the Treasury market's near-term trajectory, demanding careful watch from cash managers and risk officers alike.

Risk Assessment: Downside Scenarios and Guardrails

Recent regulatory changes and international dynamics introduce meaningful downside risks that warrant careful monitoring.

The 's new capital rule, effective April 2026, imposes a 1% leverage ratio cap on depository institutions while reducing tier 1 capital requirements by less than 2% for holding companies. This creates compliance strain for banks holding legacy securities. Institutions reliant on Treasury intermediation may face liquidity crunches if balance sheet adjustments force asset sales during market stress, particularly since the rule doesn't address 2023-2025 yield volatility.

Foreign ownership of U.S. debt at 30% creates vulnerability to capital flight. China's declining Treasury holdings reflect strategic diversification away from dollar assets. If geopolitical tensions escalate or yield curves steepen, , raising U.S. borrowing costs dramatically.

These risks compound each other: liquidity strains from regulatory changes could force domestic institutions to sell Treasuries, amplifying foreign-driven price declines. Investors should monitor two guardrails: First, the Fed's leverage cap compliance deadline (Q2 2026) for early warning signals. Second, China's monthly Treasury position changes as a leading indicator of capital flight momentum.

Current Fed forecasts show limited stress-testing for these combined scenarios, particularly regarding Treasury market depth during simultaneous regulatory and geopolitical shocks. .

Investor Guardrails: Actionable Scenarios and Positioning

Given the recent Moody's downgrade and growing fiscal concerns, investors should adopt a defensive posture. The downgrade has heightened scrutiny on U.S. debt sustainability, , . In the base case, reduce duration exposure until regulatory clarity emerges. Persistent deficits could keep yields elevated, eroding portfolio returns if positions remain overextended.

A downside scenario could unfold if fiscal deficits accelerate, forcing Treasury yields to spike and markets into sharp volatility. This would require prioritizing cash and ultra-short-duration assets to preserve capital. The Moody's downgrade and worsening deficits could trigger a loss of confidence in U.S. credit, accelerating a sell-off in longer-term bonds.

Compliance risks also demand vigilance. The Federal Reserve's new capital standards rule, effective April 2026, could reshape bank risk-taking in Treasury markets. Investors should immediately reduce positions if non-compliance with the new SLR requirements is detected, as regulatory shocks could disrupt liquidity and amplify rate moves.

Overall, maintain liquidity buffers and avoid duration until fiscal and regulatory uncertainties subside. Monitor Treasury yield trends and Moody's actions for signals of escalating risk.