U.S. Treasury bonds struggle to rebound, facing dual threats from stagflation and leveraged liquidity floods

⑴ The current three-day rebound of US Treasury bonds stalled after the auction, with long-end yields rising by about 3 basis points, but little change from the short end to the five-year term, resulting in a bear steepening of the curve. ⑵ The recent weak inflation readings are unlikely to keep core PCE year-over-year consistently below the current operating center of around 3.4%. Even if there is a mild short-term decline, underlying inflation remains significantly above the Federal Reserve's 2026 target and the long-term anchor of 2%. Coupled with additional price pressures from the Iran conflict affecting both costs and consumption, the threshold for sustained bond rebounds is extremely high. ⑶ The market may continue to bet on moderate data prompting the Fed to pause or even cut rates, but any resulting drop in long-end yields is unlikely to last, as US Treasuries are facing increasingly heavy fiscal and supply pressures. Treasury debt is approaching 40 trillion, interest payments have surpassed the defense budget, and the latest 30-year auction locked in the highest long-term financing cost since 2001. ⑷ Shifting to a mainly short-end issuance strategy has increased the frequency of rolling refinancing. Against a backdrop of stubborn inflation, investors will inevitably demand a higher term premium to absorb the constant surge in supply. ⑸ Market structure harbors hidden vulnerabilities. As of September last year, hedge funds’ total US Treasury exposure climbed to about 4 trillion, with longs around 2.4 trillion and shorts around 1.6 trillion. Much of this is financed via repos and embedded in basis and swap spread arbitrage leveraging strategies, which support liquidity under normal circumstances. However, should financing costs jump, margin requirements rise, or correlations abruptly change, volatility will be sharply amplified. Both March 2020 and April 2025 showed how leveraged unwinding can turn sell-offs into disorderly deleveraging. ⑹ Overseas pressures are intensifying simultaneously. Japanese government bond yields remain high, and the yen has weakened again to around 160 against the US dollar, increasing the pressure on the Bank of Japan to either maintain or tighten its policy. Further yen depreciation will push Japanese bond yields higher, thereby reducing the relative appeal of US Treasuries after FX hedging and placing additional drag on long-term US bonds. ⑺ Given the persistence of core inflation, massive supply, high leveraged positions, and rising Japanese bond yields, the strategy remains tactically neutral. Look to sell into rallies when the 10-year yield approaches the lower edge of the 4.55%-4.75% range, with a bias toward yields returning to the upper end of this range rather than breaking below it. On Friday, focus on retail sales, business inventories, Michigan consumer sentiment, and Federal Reserve officials’ speeches to capture short-term sentiment swings and policy signals.