Macro Musings:
AI has created a major investment boom, but it is highly concentrated and it has yet to lift the broader economy into a stronger growth regime. At least $400bn of real investment in tech sits above the pre-AI trend, driven overwhelmingly by computer equipment, where annual growth approached 80%. Yet despite this surge, broader demand growth still resembles the shallow post-GFC expansion, when annual growth in real final sales to private domestic purchasers grew at a 2.5–3.5% pace. Current growth falls well short of the larger, more diversified (and productive) expansion experienced pre the dot-com era. Today’s growth is moderate at best, considering the AI spending. Until we see broadening of activity, we remain cautious on growth trends.
Job growth has slowed again across much of the economy, with the hiring rate falling to its lowest level since 2011, limiting growth in wages (which is critical at a time of high energy prices) that drives overall consumer spending. However, advanced manufacturing has emerged as a bright spot, with stronger labor demand accompanying rising profitability in AI-adjacent sectors.
The 3-month annualized change in core PCE has reached 2%, and maintaining the recent pace of soft monthly increases would keep it near that level through year-end, easing pressure on the FOMC for further tightening. Still, the breadth of price growth remains elevated, with the share of expenditures growing above 3% and the fraction of PCE items with rising prices signaling greater inflation persistence than growth in core PCE.
Market Thoughts:
The recent strong series of UST auctions suggests that the backup has, at a minimum, created enough concession to bring out value investors. Top-ticking is usually ill-advised, but it’s possible that US long-term rates are in the process of rounding out a near-term local high as Treasuries are, in our view, in deep-value territory.
Even with the latest breakout in 1y1y from the broad range established following the super-sized 2022-23 hiking cycle, the move in near-term forwards still pales in comparison to 10y10y. Overall fiscal and supply concerns have been expressed through longer-dated forward rates and some term premia, where long-tern rates are not being driven by fundamental Fed policy alone.
Since the pandemic, USTs have been less effective as a hedge against equity drawdowns, as fiscal expansion, inflation, and elevated USTs supply have tempered bond rallies during risk-off periods. Nevertheless, with yields at historically high levels, USTs now offer both income and total return potential and thus remain a potentially important portfolio hedge and could perform again in a deeper or more prolonged equity market correction.
Lastly, The US midterms could be an important catalyst for bonds. A Democratic win could create fiscal gridlock, limit additional spending, and increase regulation around AI in 2027, supporting USTs. A Republican win could be more challenging for bonds if it enables continued fiscal expansion. If markets stabilize through the midterms, a constructive setup for high-quality fixed income may emerge, including USTs & MBS, over the next 6-12 months.
Fed and Rates View:
Fed View: The market is prepped for a much more hawkish Fed than what, we think, will ultimately be delivered. Fed funds futures are pricing roughly three additional rate hikes over the next 12 months, but our base case is that the policy rate remains at today's level over that period, with at most one additional hike in Dec ‘26 before an eventual cut in Sep ‘27. Given the potential for weaker fiscal support and fading supply shocks after the midterms, the market's expected rate path appears aggressive.
The latest SEP suggests the FOMC has become confident that labor market risks have diminished, with the diffusion index on unemployment risks turning negative for the first time since 2021 and growth risks shifting to the upside after years of fearing a growth relapse. Taken together, these revisions point to a SEP that appears influenced by recency bias. We think the FOMC may be overestimating the true health of the US labor market.
Rates View: The UST sell-off has come in three waves: in the first half of 2026 in reaction to the energy price moves, over the summer in response to a hawkish pivot from the new Fed Chair Kevin Warsh, and the final quick big reprice in September when long-bonds had one of their worst monthly performance in years due to a negative backdrop for global rates and competition from IG credit supply (overall and specific from hyperscalers).
We have shifted up our rates forecast 25-50bps in all quarters through our forecast horizon. That said, the market has priced-in a lot of the Fed path already and there is a risk it has overshot.
Special Topic – Fiscal House of Pain
Large debts and persistent deficits are a shared challenge in most advanced economies, with elevated interest costs becoming a major hurdle to achieving fiscal sustainability. In the US, interest costs are projected to become roughly twice the size of the primary deficit by 2032. Global bond market participants are keenly aware of these unsustainable debt dynamics, leading to a return of some term premia, and in the US, competition for capital is leading to some crowding out of credit for private markets.
The US Treasury will need to refinance trillions of dollars of maturing debt while continuing to fund large deficits, meaning that if yields stay elevated, the government will restack higher coupon costs into the outstanding debt, embedding higher debt-servicing costs for years. At the same time, continued reliance on short-term T-bills rather than terming out the debt makes financing costs more sensitive to short-term rates, potentially making Treasury funding more pro-cyclical, less predictable, and less stable.
Political partisanship poses a risk that the debt ceiling will not be raised or suspended in a timely manner, with a Democratic sweep or split Congress after the Midterms increasing that risk. The current pace of spending will have the US hit the debt ceiling in early FY27, necessitating the use of extraordinary measures if Congress does not reach an agreement. Further complicating this path is a big buyback program that Treasury must fund, and central clearing of repo in mid 2027 may drive s/t HQLA collateral demand.
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