Rates spark: The fiscal number can eclipse CPI

While the transition to higher US yields is linked with the war and higher energy prices, in fact the market discount for inflation is quite relaxed. The July reading is expected to see core at 2.5% YoY. Break-evens are already below this, paving an auspicious path ahead. The fiscal deficit, though, has been morphing in a more bond-negative direction.

US CPI inflation is crucial, but the market is already quite relaxed on it

We get updates on the two most important fundamental drivers of US Treasuries on Wednesday, namely US inflation and the fiscal deficit. The former impacts the real return attainable from bonds, while the latter helps determine the supply of bonds. Arguably, nothing else should matter, and if they do, it's only to the extent that they ultimately impact inflation and the supply of bonds.

Recently, the bigger attention has been more on the former than the latter, as upward pressure on energy prices in addition to prior tariff price hikes saw inflation print uncomfortably high. To the extent that these impulses have maxed out, there is a path ahead for easing in inflation as we progress through the remainder of 2026. That stems from the crucial assumption that the oil price remains contained, through an ultimate reopening of the Strait of Hormuz (in the coming weeks).

The core number anticipated for July at 2.5% year-on-year is absolutely fine, and should act as a rate that headline inflation (now at 3.5%) should trek towards as we progress through 2026. Better still, market break-even inflation rates are running at comfortably below 2.5% (actually in the 2.25% area).

In fact, the market is already discounting a mild inflation landing. It's the higher real rate component that's driven the 10yr Treasury yield higher in recent months, not inflation break-evens.

Treasuries have not been worrying much on the deficit, but should start to pay more attention

It's also true that the recent rise in the 10yr Treasury yield has not come from a deterioration in credit perception, in the sense that it's not directly linked with any delta in the deficit. We note that the 10yr swap spread has managed to hold broadly steady in the 40bp area since May. That 40bp spread is, in effect, the additional rate that Treasury Secretary Bessent needs to pay over and above the risk-free-rate (SOFR), as compensation for the elevation in the fiscal deficit (6% of GDP area).

Why has it been steady? Well, the good news is the US fiscal numbers have not deteriorated since fiscal year 2024. The deficit for fiscal year 2025 was in fact a tad lower in cash terms. And the running number for 2026 had been running steady to slightly below 2025 on account of the extra cash coming in from the tariff revenues.

However, the $75bn tariff refund paid through May and June flipped the numbers, resulting in the 2026 fiscal deficit running above 2025. Even though there has been a tariff reset/replacement, the 2026 deficit is set to run at some $200bn above the 2025 deficit. Hence, we're shaping up for a $2.1tr deficit for fiscal year 2026. The July number will likely confirm the deterioration, coming in at around the $400bn area compared with $291bn for the same month in 2025.

If so, we risk seeing a deterioration in the credit story for Treasuries, resulting in some re-widening of the 10yr swap spread. An edge back up towards the 50bp area on a multi-month view is an entirely foreseeable outcome.

Read the original analysis here