We see a continuation of the diversification trend seen in 2026. Fixed income investors may be underestimating the risk stemming from US expansionary fiscal policy. We see opportunities in inflation break-evens, and yield curve steepening later in the year. Quality credit becomes a core allocation for fixed income investors, thanks to sound fundamentals and a better risk-return profile compared to Treasuries. European bonds remain a key call for 2026, with a focus on peripheral bonds and investment grade credit, particularly in financials.
Rising US fiscal risks call for a focus on inflation and investment grade credit
Foreign holdings of US Treasuries, at almost $9 trillion, are close to record highs, but we believe international investors may be too optimistic about the long-term persistence of US exceptionalism at a time when US deficits and debt are rising and inflation risk persists. Investment in AI (as discussed previously) could raise US potential growth above 2%, but even if AI does boost productivity, it may not be enough to offset worsening demographics. US debt is unprecedentedly high, which also adds risk to Fed independence.
US bond yields have fallen in anticipation of rate cuts. We believe the weakening labour market warrants cuts down to 3.5%, but the market is periodically pricing in cuts to below 3% by the end of 2026. Monetary policy this dovish, in our view, would increase expected inflation and increase the term premium.
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