Morgan Stanley provides a reference scenario for U.S. Treasury yields in 2025-26: short-term yields drop significantly while long-term bonds support the curve peak

According to the Zhitong Finance APP, analysts from Wall Street financial giant Morgan Stanley expect that the U.S. Treasury yield curve will significantly steepen in 2025-2026. However, they emphasize that this is not due to a substantial rise in long-term yields, but rather because of an overall downward trend in yields, particularly a sharp decline in short-term U.S. Treasury yields. The long-term U.S. Treasury yield curve may remain near historical highs due to the persistently high U.S. government budget deficit, and it is expected to slightly decline towards the end of the year due to economic weakness. Before the end of the year, a so-called "term premium" may surge, during which global stocks and bonds will also face downward pressure.

Despite the expected steepening, the institution's analysts still remind investors focused on long-term U.S. Treasuries that the expectation of an expanding U.S. government budget deficit may continue to exert significant selling pressure on equity and bond markets in the coming months. In contrast, short-term U.S. Treasury yields may be on a clear downward trajectory this year and even into early next year, indicating that Morgan Stanley expects short-term U.S. Treasury prices to rise significantly more than long-term U.S. Treasuries, leading to a steepening of the entire U.S. Treasury yield curve.

Morgan Stanley's macroeconomic analysts also expect that inflationary pressures related to the tariff policies led by Trump since April will prevent the Federal Reserve from cutting interest rates in 2025, meaning that Morgan Stanley expects the Federal Reserve to choose "not to cut interest rates" this year. Morgan Stanley states that this hawkish policy stance regarding the Federal Reserve's decision not to cut rates may be priced into the market, potentially causing the U.S. Treasury yield curve, especially long-term U.S. Treasury yields, to remain within the range established over the past two years for a significantly longer time than investors expect.

In contrast, the "CME FedWatch Tool" shows that traders in the interest rate futures market are still betting that the Federal Reserve will first cut rates in September and the next cut will occur in December. Goldman Sachs' team of economists believes that the Federal Reserve is still likely to normalize monetary policy and cut rates after the negative effects related to tariffs dissipate and the temporary inflation shocks significantly ease. Goldman Sachs expects the peak inflation effects of tariffs to appear in the inflation reports from May to August and initially predicts that the Federal Reserve's first rate cut this year will occur in December.

Morgan Stanley expects yields to begin declining at the end of the year, with the entire curve gradually moving towards a steep trajectory.

However, looking ahead to the end of this year and early next year, Morgan Stanley's analyst team expects that as inflation significantly slows down around the end of this year, the U.S. economic growth rate and labor market will also weaken due to tariffs and immigration restrictions, compounded by the Federal Reserve's long-term maintenance of high interest rates. This slowdown is expected to significantly push the entire yield curve downward, with the 10-year U.S. Treasury yield likely dropping to around the important level of 4% by the end of the year.

Entering the first half of 2026, Morgan Stanley's analysis team envisions a more pronounced downward trajectory for yields, as the U.S. economic situation continues to soften. The yield curve will further steepen, with short-term U.S. Treasury yields potentially declining more significantly, indicating that Morgan Stanley expects short-term U.S. Treasuries to continue outperforming long-term U.S. Treasury prices, ultimately bringing the steepness of the overall U.S. Treasury yield curve below the overall levels seen in the past two years As of Monday's close of the U.S. stock market, the 10-year U.S. Treasury yield was around 4.5%, while the short-term 2-year U.S. Treasury yield hovered around 4.03%. The longest duration, which is currently the least favored by the market, the 30-year U.S. Treasury yield was approximately 4.93%, getting very close to 5%.

Under expectations of expanding deficits, long-term U.S. Treasury yields may remain high for an extended period

In the "U.S. Treasury Yield Curve Trajectory" scenario proposed by Morgan Stanley's analyst team, short-term U.S. Treasury yields are expected to enter a sustained downward trajectory, while long-term U.S. Treasuries will continue to hold the highest peak of the curve until the end of the year. This means Morgan Stanley anticipates that the price of short-term U.S. Treasuries will rise stronger than that of long-term U.S. Treasuries at least until the end of the year, while long-term U.S. Treasury yields may remain high or even occasionally spike due to the heavy pressure of budget deficit expansion, potentially driving the "term premium" to hover at its highest level since 2014 or even 2013, leading to renewed volatility in the global stock and bond markets.

In recent weeks, global long-term sovereign bond yields have surged; investors are generally worried about the increasingly swollen U.S. debt and deficits. Some choose to avoid such long-term securities, while some investment giants focusing on bond assets demand higher "term premiums" due to risk concerns.

The 10-year U.S. Treasury term premium, which measures investors' worries about Washington's future borrowing scale, is currently hovering at its highest level since 2014.

The so-called term premium refers to the additional yield compensation that investors require for holding long-term bonds. Looking ahead to the next few years, imposing tariffs may even become a common consensus in the Western world. Therefore, in an increasingly divided "de-globalization" era, the ever-expanding U.S. debt interest, military defense spending, and domestic policies led by the Trump administration's tax cuts are embarking on a path of significant expansion. The market's concerns about the sustainability of the U.S. government's massive debt and long-term inflation risks have significantly intensified, and the dreaded "term premium" is poised for a comeback. The 10-year U.S. Treasury yield, which serves as an anchor for global asset pricing, is even brewing a wave of growth that could be wilder than the surge to over 5% in 2023.

Some economists believe that in the "Trump 2.0 era" after returning to the White House, the issuance of government bonds and budget deficits will be much higher than official forecasts, mainly because the new government led by Trump will focus on "domestic tax cuts + external tariffs" as a framework for economic growth and protectionism. Coupled with the increasingly large budget deficit and U.S. debt interest, the U.S. Treasury's bond issuance may be forced to expand even more than the Biden administration's excessive spending during the "Trump 2.0 era." Additionally, under "de-globalization," China and Japan may significantly reduce their holdings of U.S. Treasuries, making the "term premium" inevitably higher than before.

A higher "term premium" means higher yields, which may lead the stock and bond markets to remain on a downward trajectory. It also means that as U.S. borrowing demand rises and government spending remains robust, financing pressure will intensify. The version of the fiscal and tax cut bill led by Trump that passed the House of Representatives is predicted by some institutions to add trillions of dollars to the U.S. budget deficit in the coming years Moody's downgraded the U.S. credit rating last month, resulting in the U.S. government losing its top sovereign credit rating from all three major rating agencies.

The fixed income strategy team from Charles Schwab shares a similar view with Morgan Stanley. "Overall, a steeper yield curve is the most likely scenario," said the team led by Chief Fixed Income Strategist Kathy Jones at Charles Schwab. "If the data is weak enough and the Federal Reserve announces a rate cut, short-term yields will be significantly lowered, but long-term U.S. Treasury yields will still be constrained by expectations of worsening budget deficits, high debt yields, expectations of a long-term weakening of the dollar, and concerns about capital inflows."