Shenwan Hongyuan Group Co., Ltd. has released a report suggesting that U.S. fiscal deficit pressures may re-escalate in the future. Firstly, potential IEEPA tariff rebates could constitute a new fiscal shock, potentially raising the deficit-to-GDP ratio by 0.5 to 0.6 percentage points. Secondly, the U.S.-Iran conflict may lead to military spending expansion. For the 2026 fiscal year, U.S. defense appropriations total $838.5 billion, with $529 billion already utilized as of April. Should the U.S.-Iran conflict persist, existing appropriations may prove insufficient.

Global pressures on long-term bonds are not over, and a potential decline in U.S. Treasury yields could face constraints from external interest rates. In the UK, if Burnham wins the by-election on June 18 and formally initiates a leadership challenge, political uncertainty could intensify, potentially pushing UK gilt yields higher. In Japan, if Japanese Government Bond (JGB) yields continue to rise, the attractiveness of domestic Japanese assets may increase further, potentially altering the investment rationale for U.S. Treasuries.

AI investment may become a new variable driving up U.S. Treasury yields. Firstly, concentrated bond issuance by AI companies directly increases duration supply in the market. Secondly, interest rate swaps could create synthetic duration supply pressure. Thirdly, on the demand side, it could squeeze the market's capacity to absorb duration. Against the backdrop where U.S. Treasury investors are already predominantly domestic, competition among AI corporate credit bonds, financial bonds, and Treasuries could elevate the equilibrium rate for long-term capital.

Shenwan Hongyuan's main views are outlined below:

Since the onset of geopolitical conflicts, U.S. Treasury yields have risen significantly. While the current market analysis primarily focuses on oil prices, inflation, and monetary policy, a decomposition of the yield structure reveals that the resilience of the U.S. economic fundamentals has contributed more to the rate increase, and new disturbances may emerge in the future.

1. Key Considerations: Reassessing U.S. Treasury Risks – To Be Continued a) Deconstructing the Rise in U.S. Treasury Yields: Economic fundamentals have contributed more than inflation expectations, suggesting the rate increase may be more persistent. The entire U.S. Treasury yield curve has shifted upward, with the middle segment (2-7 years) experiencing the most significant rise. This indicates the market is primarily pricing in a withdrawal of expectations for future rate cuts. The increase at the long and ultra-long ends has been less pronounced, suggesting the market is not yet heavily trading on fiscal risks. The yield rise occurred in two phases: the first was driven by risk-neutral rates, and the second saw an accelerated increase in term premiums, reflecting rising market demands for compensation and policy uncertainty. A further breakdown shows the rise was not primarily driven by inflation; the contribution from economic fundamentals was greater. Since the U.S.-Iran conflict, real short-term rate expectations rose by 15 basis points, while inflation expectations rose by 9 basis points.

b) The Primary Contradiction for U.S. Treasuries: Rising Bond-Oil Correlation, Economic Resilience, and External Risks Crude oil has become a key variable in Treasury pricing, suppressing rate cut expectations. The correlation between Treasuries and oil has increased significantly post-conflict. The U.S. economy's actual performance, stronger than market expectations, is a crucial support for higher yields. Economic data, from manufacturing to consumption, indicates ongoing expansion momentum. Stronger evidence of economic weakness would be needed for yields to decline. External triggers for rising U.S. yields include UK political risks and Japanese debt supply pressures. UK election setbacks and rising JGB yields have amplified global long-bond volatility, contributing to spikes in U.S. Treasury yields.

c) Variables Potentially Underestimating the H2 Yield Benchmark: AI Investment as a New Factor Future U.S. deficit pressures may expand. IEEPA rebates and potential military spending due to the U.S.-Iran conflict are key factors. Global long-bond pressures persist. U.S. yield declines could be constrained by external rates, with potential further uncertainty in UK politics and shifting investment flows if Japanese yields rise. AI investment may elevate U.S. Treasury yields through increased duration supply from corporate issuance, synthetic supply pressure from swaps, and demand-side constraints on duration absorption. Competition among AI credit, financials, and Treasuries could push up the equilibrium long-term rate.

Risk warnings include escalating geopolitical conflicts, a U.S. economic slowdown exceeding expectations, and a more hawkish-than-expected shift by the Federal Reserve.