The Big Idea
A likely floor for now on 10-year rates
This material is a Marketing Communication and does not constitute Independent Investment Research.
Even if inflation gets back to the Fed’s target, it may be a while before 10-year rates have a chance to drop below 4.25%. Surging US tech company demand for funding is part of the reason, but the US government is also doing its share to prop up longer rates. Federal deficit spending is on track to exceed fiscal 2026 expectations by nearly $330 billion. The borrowing demand has pushed up real rates and left little room for longer rates to fall even if inflation eases.
The fiscal 2026 federal deficit reached $1.8 trillion through July, matching the Congressional Budget Office’s February projection for the full year. If August and September match this year’s $164 billion monthly average deficit, the final tally will exceed the CBO projection by $328 billion or nearly 15%. Meanwhile, tech companies have issued $308 billion this year to fund AI infrastructure, nearly 13 times the pace over the first seven months of 2025.
Steady federal deficits tend to push rates higher when foreign investors provide a significant share of the funding. And although foreign holdings of US Treasury debt have fallen from a peak of 56% in 2008 to 30% today, they remain large enough to affect rates (Exhibit 1). A rising US debt-to-GDP ratio adds to the sensitivity. Significant foreign demand for US corporate debt may be amplifying the effect.
Exhibit 1: Foreign portfolios still hold 30% of marketable Treasury debt
Source: Bloomberg, Santander US Capital Markets
The demand has pushed up real rates across maturities this year. Since early March, the 5-year real rate has climbed 104 bp, the 10-year up 70 bp and the 30-year up 57 bp (Exhibit 1). Real rates reflect where the demand and supply for money balance, and demand from tech and government clearly is strong.
Exhibit 2: US real rates have moved up significantly since early March
Source: Bloomberg, Santander US Capital Markets
If the Fed does wrestle inflation back to the 2% target, the market is offering limited room for relief on longer rates. The 5-year breakeven inflation rate closed late this week at 224 bp with the 10-year at 227 bp, levels already consistent with a 2% PCE. Even if breakevens drop to 200 bp, there’s limited room for rates to fall more than 25 bp unless the economy falls into recession. If government and tech demand for funding stays strong, the 10-year rate is likely to find a floor at 4.25%.
Exhibit 3: Breakeven 5- and 10-year inflation already is consistent with 2%
Source: Bloomberg, Santander US Capital Markets
The US Treasury seems intent on limiting supply pressure in longer maturities by holding coupon auction sizes steady and funding deficit growth with bills. That may relieve some pressure on longer real rates for now. But eventually Treasury looks bound to increase coupon auctions unless it decides to permanently change its funding mix.
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The view in rates
The market is pricing about 24 bp of Fed tightening by the end of 2026 and little change in 2027. That should keep the front end of the curve at 4.00% or higher through 2026, depending on expected short-term inflation. Renewed US-Iran conflict could push the expected Fed path and short-term rates higher. The 10-year Treasury note will likely spend more time above 4.40% than below it for the rest of the year with a floor of 4.25% running into 2027. A durable US-Iran agreement could pull the yield below 4.40%, but technology companies’ and government demand for cash is likely to keep longer-term rates high.
Key market levels:
- Three-month term SOFR was set Friday at 374 bp, down 1 bp in a week.
- The 2-year Treasury note traded Friday at 4.17%, down 2 bp in a week. The 10-year note traded at 4.69%, up 5 bp.
- The Treasury yield curve traded Friday with the 2-year/10-year spread at 52 bp, 7 bp steeper on the week, and the 5-year/30-year spread at 90 bp, 5 bp steeper.
- The 10-year inflation breakeven traded Friday at 228 bp, up 3 bp in a week. The 5-year, 5-year forward breakeven was 231 bp, down 3 bp. The 10-year real rate ended the week at 241 bp, up 1 bp.
The view in spreads
The supply-demand balance looks neutral to negative for MBS, neutral for corporate debt overall and especially weak for technology debt. MBS net supply remains low, but the expected steady demand from Fannie Mae and Freddie Mac has not appeared. Insurers continue to issue annuities and buy corporate and structured credit, but credit markets face heavy financing needs for capital investment. In risk assets. Carry will likely drive returns. Stay overweight MBS and favor higher coupons to add carry and reduce spread duration. Stay overweight corporate credit overall but underweight technology.
The Bloomberg US investment-grade corporate bond index option-adjusted spread traded Friday at 78 bp, 1 bp wider on the week. Nominal par 30-year MBS spreads to a blend of 5- and 10-year Treasury yields were 109 bp, 4 bp tighter. Par 30-year MBS treasury option-adjusted spreads closed at 23 bp, unchanged on the week.
The view in credit
Large companies have healthier balance sheets than smaller ones. Middle- and higher-income consumers also carry relatively little debt and have strong liquidity and wealth. Bank lending to nonbank financial institutions, including private debt funds and business development companies, continues to grow. Regulators remain focused on this lending, which could eventually tighten private credit markets. For now, however, credit measures for nonbank financial lending remain stronger than those for traditional bank lending, such as commercial and industrial loans.
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