Fixed Income: Yields trading near low end of fair value range, moderately biased upwards

NotesUSnoramdmfixed incomePolicy

The recent fall in 10-year US yields puts them near the lower end of our fair value estimates while the rolling total return from 10y USTs is also in the middle of its long-trend.

Our estimate of R* - the real short-term neutral rate - is still at 1.4%, which is also where the 5y5y real OIS is trading. We use the 5y5y real OIS as a proxy for the market-implied R*. Again, this shows yields are not wildly mispriced.

The 2s5s10s butterfly is starting to tick up. When this is low and negative, we interpret that to mean the market is discounting a Fed easing cycle that restores growth, whereas when this is high, it’s a sign the market is worrying about a Fed hiking cycle that slows the economy. We used this in January to warn of a yield peak (link). Today the bottoming in the 2s5s10s can be interpreted as saying the market has already priced in peak easing.

There isn’t much room for short-term rate expectations to fall further absent a recession given the SOFR-implied rate of ~3.0% by 4Q26. Our R* estimate plus inflation of ~3% suggests the nominal neutral policy rate is near 4.5%. The risk is the Fed cuts lead to accelerating growth and inflation in 2026, implying we should retain a moderate bias towards yields higher.