Key Highlights

• Yields spike as inflation and policy concerns mix with fiscal worries.
• RMPs cut back this month, suggesting the Fed is comfortable with liquidity conditions.
• We no longer see two cuts for this year as skepticism grows that the Strait of Hormuz will open soon

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Bond selloff deepens

EXHIBIT #1:  FOREIGN UST DEMAND WEAK – POTENTIALLY GETTING WEAKER

_Source: BNY

With no concrete action on the Strait of Hormuz coming out of the Trump–Xi summit last week, bond markets are sending a bearish message. The U.S. 10y yield is now comfortably above 4.6% and rising, and the long bond is well above 5%. The 10y benchmark yield has moved about 20bp higher since Monday last week and in total now sits more than 65bp above its level the day before the conflict broke out. Interestingly, according to breakevens, inflation expectations have only moved about 25bp, while real rates – reflecting both policy expectations and risk premia – have gone up just under 40bp. 

We would expect further strain at the back of the curve as long as the geopolitical situation in the Middle East persists. This is a meaningful concern: higher yields across the curve strain both risk assets and the real economy. It’s not clear to us that even if the Fed were to raise rates, it would have a constructive effect on longer end yields, given that much of their moves are on the real rate side. Indeed, given that the majority of the pickup in yields is due to the market’s hawkish policy expectations, we would see a tightening move as simply validating these existing hawkish expectations. We’d add that, as discussed below, we no longer see cuts this year. 

There’s no mystery to the bond selloff. Higher expected inflation, higher expected policy rates, and a steady (about 70bp) term premium are all quite reasonable. It’s fair to ask why yields hadn’t moved more before last week. This is global in nature, with yields ratcheting higher across major economies, and we think they all share the same drivers – inflation fears, policy expectations, and perhaps fiscal concern. The Treasury’s quarterly refunding announcement does not signal coupon size increases in 2026, but the Treasury Borrowing Advisory Committee minutes suggest this will likely have to change in 2027.

Foreign demand for USTs has been waning – a concern we have written about frequently (see here and here). We don’t think this will change anytime soon, even with prices now at more attractive levels. Coupon auctions have seen tails and high yields, and in any case, cross-border investors have access to similar yields in their home markets. Exhibit 1 shows falling demand for U.S. sovereign risk since the beginning of the year. Until the conflict eases, we don’t see this changing, and we think 5% on the U.S. 10y is potentially achievable – which would mark the first time that round number has been seen since October 2023. 

RMPs further cut – Fed seems comfortable with market liquidity

EXHIBIT #2:  REPO MARKET STABILITY ALLOWS FURTHER REDUCTION IN RMP SIZE

_{Source: BNY, Bloomberg}

Last week, the New York Fed announced it would be reduce its monthly reserve management purchases (RMPs) to $10bn, down from $25bn the month prior. This was the second consecutive month of reductions, following a period of $40bn per month from the start of the year through Tax Day. RMPs were originally designed to ensure that reserve levels in the banking system remained ample enough to support smooth money market functioning, particularly after the funding stresses seen in prior episodes of reserve scarcity. In that context, the Fed’s decision to maintain purchases at elevated levels through mid-April reflected a cautious approach toward seasonal funding pressures and the risk that reserve balances could become unevenly distributed across institutions.

That cautious approach, however, has meant that nearly $200bn has been injected into the system since mid-December. Funding markets are awash with liquidity and well-contained, even on days that would historically have seen funding stress. 

The most recent example of this is Friday’s mid-month settlement, which saw the repo market easily digest $125bn of coupon supply. Money markets barely blinked, with overnight SOFR printing 3.55% (the lowest of the year). Moreover, the spread between the tri-party general collateral repo and IORB fell to negative 12bp, the lowest of the year and below the negative 11bp seen before Tax Day in early April. Exhibit 2 shows the spread of TGCR over IORB since the beginning of the year. Clearly, RMPs have shored up liquidity in the repo market.

Though some in the market had anticipated a reduction in the pace of RMPs, the extent of the pullback surprised us and many others. The decision shows that the Fed is not just comfortable with the level of reserves in the system, but also confident in the market’s ability to absorb routine pressures without renewed intervention.

Rates outlook

Our call for two cuts by the end of this year is very much in doubt as it rested on two outcomes. First, we assumed the Strait of Hormuz would open before August; second, we assumed a weakening labor market. With the former looking increasingly dim and the latter not yet materializing, we’ve revised our outlook. We now see the Fed on hold for the rest of the year and have pushed further easing into 2027, assuming oil and other key input markets will begin to stabilize by then. 

We retain our view that if shipping from the Persian Gulf resumes sooner, rate cuts would follow not long after. However, we recognize that now – almost into June – there is little sign of a climbdown by either side. We still believe that if a condition is unsustainable, it will, by definition, not be sustained, but we are becoming increasingly skeptical that this will happen soon enough to allow for 2026 cuts to proceed. Breakthroughs are not out of the question, and if they were to occur, we would put rate cuts back on the table. We believe the market would agree with us in that case. But from here, we have no visibility into when shipping traffic would be able to resume.

If labor market conditions remain in their current equilibrium – moribund or even flat job growth, but no significant losses – the unemployment rate will remain steady between 4.1% and 4.4%. Absent a pickup in the unemployment rate, and in the face of rising bond yields and prospects for a further upside to inflation, the Fed cannot move toward easing. In some ways, our revised outlook reflects a midpoint between two scenarios: rate hikes, if inflation keeps rising while jobs hold steady; and the scenario we held until today – falling oil prices, easing inflation expectations, and a deteriorating labor market – which had pointed to cuts.

This is a tricky time for markets and Fed watchers, given the uncertainty in forecasting a binary outcome on the Strait of Hormuz. Yet with no clear view of when and how that might change, we can no longer justify a policy outlook that depends on it. We remain ready to shift back to calling for cuts should the situation in the region change, but for now we – like the rest of the market – remain on hold.

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