US Bond Investors Bet on Steeper Curve as Deficits Grow

Bond investors are increasingly positioning for a steeper United States yield curve, a strategy that anticipates short-dated Treasuries outperforming the long end of the market. This shift reflects a growing consensus that the Federal Reserve will eventually move toward interest rate cuts, even as the government faces mounting fiscal deficits and long-term inflation risks. In a steepening environment, yields on longer-dated debt rise faster than short-term maturities as investors demand higher compensation for holding assets exposed to extended risks.

This market stance has persisted despite geopolitical volatility in the Middle East. While the conflict involving Iran has created uncertainty, recent data suggests a cooling of immediate panic. The MOVE index, a key measure of interest rate volatility, recently fell to a five-week low of 72.15, down significantly from its March peak. This decline indicates that bond players may have already factored in the most severe potential disruptions to the global economy.

Padhraic Garvey, head of global rates and debt strategy at ING GROEP NV, suggests that the current environment makes the steepener trade a logical choice for many portfolios.

We think ultimately this will die away slowly but surely.

Garvey noted that while inflation expectations continue to weigh on the back end of the curve, there is little expectation that the Federal Reserve will respond to current pressures by hiking rates further.

The back end of the curve has issues with inflation expectations and on the front end, we are not expecting the Fed to react by hiking rates.

Economic projections also highlight the dual pressure of energy costs and fiscal spending. Brent Crude Oil is expected to average $96 a barrel this year, driven by supply concerns and the potential for a prolonged blockade of the Strait of Hormuz. While higher energy prices typically fuel inflation, they also pose a threat to consumer demand and the labor market, which could ultimately force the central bank to ease policy to support growth.

Vishal Khanduja, head of the broad markets fixed income team at MORGAN STANLEY, believes that cracks in the employment sector will eventually become the primary driver for rate adjustments.

There is underlying weakness in the labor market that will become a lot more apparent as you go through the quarters.

Khanduja pointed out that the 5/30 yield curve—the spread between five-year notes and 30-year bonds—has significant room to widen. On Monday, this spread was measured at 96.9 basis points, recovering from a low of 82 basis points seen during the height of recent regional hostilities.

Beyond economic growth concerns, the long end of the Treasury market is being undermined by heavy government issuance. The Pentagon is currently seeking more than $200 billion in supplemental funding for military operations, which comes on top of a $900 billion defense bill for fiscal year 2026. This massive borrowing requirement ensures a steady supply of new debt, keeping upward pressure on long-term yields.

Guneet Dhingra, head of U.S. rates strategy at BNP PARIBAS, argues that the case for a steeper curve remains strong even if regional tensions escalate further.

If escalation continues, the focus is going to turn toward: where is the funding for this going to come from?

Dhingra emphasized that persistent increases in the defense budget create a scenario where front-end yields remain anchored by growth concerns, while the long end rises to accommodate the growing national deficit.