US budget keeps dollar weak; lower yields still expected

The passage of the Trump administration’s budget legislation does not change our expectation that US 10-year Treasury bond yields will fall over the next 12 months. The weaker US dollar supports global liquidity.

We expect the US budget to increase the US deficit by USD 4 trillion over a decade, without boosting US growth prospects. A worsening of an economy’s fiscal outlook, generally accompanied by an increase in government borrowing or spending, often results in investors requiring a higher premium to hold longer-term debt. Indeed, we can think of interest rates as reflecting the expectation of evolving short-term rates, plus a premium that compensates investors for holding longer maturities.

The US term-premium (approximated as the difference between 10-year and 2-year US Treasury yields for example, or as inferred by the US Federal Reserve) turned positive at the end of 2024 for the first time in 10 years, but remains moderate compared with the previous two decades (see chart). Somewhat reassuringly, US 5-year Credit Default Swap spreads, or the cost of insuring against a US sovereign default, have moved little since the passing of the US legislation. This may indicate that while the impact on the US debt ceiling is higher than initially drafted, the effects on US term premia may be more moderate than in the past.

More importantly however, term premia are heavily influenced by cyclical factors. They tend to be highest just before recessions, when investors expect steep cuts to interest rates. We do not expect a recession in the US, but slower growth, and therefore a moderately higher US term-premium ahead.

Historically, higher term premia coupled with expectations of lower Fed Fund rates have been associated with phases of dollar depreciation, though, as a reflection of rising fiscal policy concerns and an economic slowdown together with a declining yield advantage for the dollar.

We see the dollar continuing to trade around fair value

International investors remain focused on the structural and long-term implications of the budget legislation, especially its potential to fuel inflation and widen fiscal deficits over time, despite likely increases in tariff revenue. These factors have been capping confidence in the US dollar. Even if the dollar currently appears oversold, making a short-term rally possible, we expect any strengthening to be limited; we hold a neutral view on the DXY dollar index, but expect it to remain weak in the coming months. Since the fiscal package widens the US budget deficit without improving the country’s growth outlook, we see the dollar continuing to trade around fair value which, for the EURUSD, we think is currently between 1.15 – 1.20, with volatility likely to remain high.

US Treasury yields should still head lower

The 3 July non-farm payrolls report indicated that the American job market is holding steady, and investors slightly tempered their expectations for an imminent interest rate cut from the Federal Reserve, providing some support to the dollar. However, even that strength proved fleeting, as the USD was quick to reverse gains. We still expect US unemployment to rise by the end of 2025, reflecting corporate hiring freezes and slower consumption growth. For now, we continue to anticipate three policy rate cuts from the Fed this year – that would take policy from restrictive into neutral territory, in other words to a level that neither stimulates nor stalls economic growth.

After the job report, fixed income markets also saw 10-year US Treasury bond yields rise back above their 200-day moving average, a measure of market trends, with yields of more than 4.3%. Current high yields explain some of President Trump’s persistent demands over recent weeks that the Fed lower rates. Still, we do expect Treasury yields to progressively decline over the next 12 months, as US growth slows and the Fed cuts rates later this year.

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US Treasury demand from foreigners is currently undermined by unattractive yields when hedged into investors’ reference currencies. Indeed, while US rates are currently higher than, say German government Bunds, it costs a euro-denominated investor more to hedge Treasury holdings than to invest in Bunds. This may limit foreign demand for US Treasuries. As the Fed cuts rates, hedging costs and return expectations for US Treasuries would likely improve, and eventually support renewed foreign demand.

As the Fed cuts rates, hedging costs and return expectations for US Treasuries would likely improve… supporting foreign demand

Also, it is important to note that domestic US investors hold around two-thirds of the US Treasury market. In addition, the US administration is currently making regulatory changes that would alleviate Treasury liquidity and demand, including steps to relax bank capital requirements. Second, the Genius Act (“Guiding and Establishing National Innovation for US Stablecoins”) will promote stablecoin issuance - crypto currencies typically pegged to a reserve asset such as the US dollar and backed by high liquid quality assets such as US Treasury bonds.

USD weakness supports global liquidity and equities

We do not think that the US deficit is a concern for equity markets unless inflation is re-ignited, and that then prevents the Fed cutting interest rates as investors expect. This is not our base case. We see the Fed cutting policy rates to neutral as inflation averages 2.8% in 2025 and 2.7% in 2026.

At face value, US dollar weakness offers a positive “global liquidity” event by easing financial conditions and supporting risk assets, in particular emerging market (EM) equities, and so can create a tailwind for stock markets. A weaker dollar can also reduce the cost of capital for multinational corporations while boosting the foreign earnings of US firms’ revenues.

EM currencies have already capitalised on shifting sentiment and the falling capital costs of recent months. With the USD weakening, and global risk appetite improving, capital has flowed back into higher-yielding EM assets. This rotation reflects both investors’ search for yield and their reassessment of relative value, especially as the US policy mix becomes more expansionary. Finally, the US legislation contains substantial, but less dramatic-than-expected cuts to 2022’s Inflation Reduction Act. It also leaves open a window that protects tax credits for a year, and may help to accelerate investment in cyclical sectors.

The relationship between US fiscal dynamics, inflation, Fed policy, and global capital flows will therefore be critical to monitor in the coming weeks.