EXECUTIVE SUMMARY
● Calendar timing shifts ($72B) and one-time IRA grants ($17B) account for approximately 75% of the reported $185B improvement; adjusted improvement is merely $98B.
● The $195B surge in customs duties (292% YoY) will erode via trade diversion within 12–36 months and faces Supreme Court invalidation risk (approx 35–40% probability), potentially forcing $90B+ refunds.
● Permanent TCJA extension and new deductions (tips, overtime, senior) add $4.1–$4.6 trillion to 10-year debt, establishing a new deficit floor of $1.7–$2.0 trillion (approx 6–7% of GDP).
● Net interest will reach $1.8 trillion by 2035 (4.1% of GDP, 28% of revenues), creating acute fiscal crowding-out and vulnerability to r > g debt spirals.
● Japan’s transition from carry-trade buyer to net seller (BoJ rate hike to 0.75%) and China’s ongoing divestment remove price-insensitive demand; the Fed’s RMP program is de facto monetisation.
● Base case (60% probability) of slow fiscal deterioration; bear case (25%) of bond vigilante strike and loss of sovereignty; bull case (15%) of productivity miracle enabling debt stabilisation through growth.
OPENING THESIS
The United States federal deficit narrowed by approximately 19% year-over-year in the first two months of Fiscal Year 2026, dropping to $439 billion from $624 billion in the comparable 2025 period.
Global capital markets have capitalised aggressively on this signal, pricing in a scenario where tariff revenue and fiscal restraint have fundamentally stabilised the trajectory of American sovereign borrowing.
Credit spreads remain compressed.
Equity valuations price in low-to-moderate volatility in long-duration assets.
At Bancara, we dissent from this consensus.
Our in-depth forensic analysis of the Treasury data, coupled with a granular decomposition of the structural elements driving the fiscal surface, yields a single conclusion.
The current deficit narrowing represents a temporary optical illusion, what we term a fiscal headfake. This improvement is driven by non-recurring timing shifts and initial revenue bursts that are both diminishing and legally tenuous. It also relies on one-time discretionary adjustments that are fundamentally unsustainable.
Beneath this veneer of stability, the underlying trajectory is one of structural deterioration, characterised by rising debt service costs, a seismic shift in the foreign buyer base for the U.S. Treasuries, and the permanent embedding of tax cuts that have rendered the structural deficit floor substantially higher than the pre-2020 baseline.
The durability of the current deficit improvement extends, at maximum, through mid-2026.
By late 2026 and into 2027, we expect a reversal toward a structural deficit of $1.7 trillion to $2.0 trillion, or approximately 6–7% of GDP.
This is not a temporary downturn.
This is the new structural reality.
This outcome precipitates a prolonged shift toward fiscal dominance.
In this state, the Federal Reserve effectively serves the Treasury’s refinancing demands. This compels the central bank to suppress interest rates below natural market levels. The result is a structural steepening of the yield curve, significant volatility in long-duration assets, and ultimately, a segmented financial system. Within this system, nominal growth persists while real returns erode.
We outline the evidence for this view across six dimensions: the arithmetic of the current improvement, the durability of tariff revenue, the structural costs of the One Big Beautiful Bill Act (OBBBA), the mathematics of debt-service dynamics, the regime change in global Treasury demand, and the multi-scenario outlook through 2035.
THE ARITHMETIC OF ILLUSION
To evaluate the durability of the fiscal signal, one must first strip away the calendar noise and accounting tricks that obscure the underlying structural reality.
The Calendar Timing Shift: $72 Billion of Phantom Improvement
A significant portion of the headline deficit reduction is attributable not to fiscal discipline, but to the Gregorian calendar.
Federal accounting protocol mandates the acceleration of scheduled benefit payments to the preceding business day if the first of the month coincides with a non-business day. This policy encompasses entitlements such as Social Security, Supplemental Security Income, Veterans’ benefits, and active duty military compensation.
Conversely, when monthwise ends land such that no weekend/holiday acceleration is required, or when the following month begins on a business day, payments occur on schedule.
In Fiscal Year 2025, specifically November 2024, the calendar conspired to inflate spending. Because 1 December 2024 fell on a Saturday, the Treasury disbursed December’s benefit payments in late November, artificially bloating outflows for the October-November 2024 period by approximately $72 billion. This “pull-forward” effect created a severely elevated year-over-year comparison base.
In Fiscal Year 2026 (October-November 2025), the calendar was less distortive in the same direction.
Consequently, the headline year-over-year deficit reduction of $185 billion evaporates to roughly $98 billion when adjusted for these timing shifts. This represents a material difference. The adjusted figure is 47% lower than the reported improvement.
The Congressional Budget Office and the Bipartisan Policy Center both acknowledge this adjustment in their baseline analyses, yet the Treasury and political commentators rarely emphasise it in public communication.
While an adjusted deficit reduction of approximately $100 billion is still notable, it pales against the structural operating deficit of the U.S. government and the magnitude of the forward liabilities embedded in the OBBBA.
One-Time Grants and Base Effects: The IRA Hangover
The second major driver of the apparent deficit improvement is a base-effect phenomenon related to the Inflation Reduction Act (IRA).
In November 2024, the Environmental Protection Agency released a massive tranche of $17 billion in clean energy grants funded by the IRA’s green energy tax credits.
This represented a singular, concentrated liquidity event, effectively clearing the grant pipeline after years of administrative processing.
In November 2025, no comparable grant release occurred.
The year-over-year comparison thus shows a $17 billion “improvement” in EPA outlays simply because the prior year had an exceptional event that has now normalized. This is a pure base effect, not a reflection of any policy change or spending restraint.
Removing the impact of the IRA grant reveals a significantly smaller underlying improvement in the operating deficit.
The genuine discretionary policy-driven deficit reduction resulting from actual spending cuts or revenue increases stands closer to $50 to $60 billion for the two-month period. Annualised, this figure is approximately $300 to $360 billion.
Discretionary Spending Cuts: Real, but Non-Recurrent
The one genuine source of deficit improvement is a severe contraction in non-defense discretionary spending, driven by the Trump administration’s 2026 budget priorities.
The Environmental Protection Agency experienced an 85–93% collapse in outlays in November 2025 compared to November 2024.
However, this cliff is a function of the combination of the aforementioned IRA grant base effect plus administrative hiring freezes and the deferral of new obligations. While real, this constraint cannot be repeated year-over-year without crossing political and legal thresholds (e.g., statutory mandates for specific programs, lawsuits over impoundment, congressionally-mandated funding levels for research agencies).
The Department of Education saw outlays fall by $7 billion (-21%) in the first two months of FY 2026. This reflects the expiration of pandemic-era stabilisation funds and the suspension of income-driven repayment initiatives.
This is a genuine occurrence, yet it lacks the critical element of repeatability.
Once the prior administration’s programs are fully wound down, there is no further reduction available without legislative action.
The Department of Homeland Security reported a $7 billion (-38%) reduction in FEMA disbursements in November 2025, partly due to the October-November 2025 government shutdown disrupting relief payment processing.
This is a timing deferral, not a saving.
As climate events continue, these liabilities will resurface, likely necessitating emergency supplemental appropriations that will re-widen the deficit in subsequent quarters.
The critical insight reveals the discretionary spending reductions evident in early FY 2026 represent singular clearances of specific programs or one-off administrative freezes. These measures are not repeatable in successive years without fully depleting the available policy options or provoking legislative or judicial opposition.
The New Deficit Floor
When these transient factors are excluded, the true operating deficit for early FY 2026 annualises to approximately $1.5–$1.6 trillion.
This is below the FY 2025 outturn of $1.8 trillion, but meaningfully above the pre-2020 baseline of $0.9–$1.1 trillion.
The gap represents the structural impact of the OBBBA, which we examine in detail.
Viewed over a decade (FY 2019–2025), the U.S. federal deficit has oscillated between $1.38 trillion (FY 2022, a post-pandemic revenue spike) and $3.13 trillion (FY 2020, peak COVID stimulus). The median is approximately $1.75 trillion, or roughly 6.2% of GDP.
The fiscal year 2026 outlook, at $1.5–$1.7 trillion, positions the U.S. at the lower boundary of this high range. This represents a temporary relief, not a fundamental structural change.
U.S. Federal Deficit as % of GDP: The Fiscal Illusion (2019–2035)
The accompanying data clearly indicates the deficit temporarily lessens in 2026 compared to 2025. However, the long-term trend is unequivocally worsening once the structural pressures of the OBBBA, interest expenses, and an aging population resume their influence. Without significant policy changes, the deficit is projected to hit 7.5% of GDP by 2035. This level would place the debt-to-GDP ratio on an unsustainable, explosive trajectory.
THE REVENUE REVOLUTION—TARIFFS AS THE NEW FISCAL ENGINE
The most radical and unstable component of the deficit improvement narrative is the reliance on tariff revenue as a quasi-permanent revenue source. This represents a fundamental pivot in the revenue composition of the U.S. government, with profound implications for both economic growth and fiscal stability.
The Tariff Surge: Historical Anomaly
The magnitude of the tariff revenue increase is staggering.
In November 2025 alone, customs duties surged to nearly $31 billion, representing a 292% increase year-over-year.
Customs duties for Fiscal Year 2025 totaled $195 billion. This figure represents a significant elevation from the historical annual range of $40 to $80 billion.
U.S. Federal Deficit as % of GDP: The Fiscal Illusion (2019–2035)
This explosion is driven by a layered tariff architecture implemented via “Liberation Day” executive orders and subsequent legislation:
- Section 301 & 232 Expansion: Duties on steel and aluminum were raised to 25–50%, with specific Chinese imports facing levies exceeding 60%.
- Universal Baseline Tariff: A 10% tariff on nearly all imports has effectively monetised the consumption of foreign goods.
- Effective Rate: The weighted average tariff rate on United States imports has dramatically escalated from approximately 1.5% in 2022 to exceed 22% by late 2025. These are levels unseen since the initial years of the 20th century.
For context, the average U.S. tariff rate during the height of the Smoot-Hawley era (1930s) was roughly 45%.
The current regime, at 22% effective, is therefore mid-range by historical standards but extraordinary by post-WWII norms.
The revenue consequences are proportionally dramatic.
The Durability Problem: Trade Diversion and Elasticity
The critical question for fiscal sustainability is whether this tariff revenue stream will persist.
Economic history and trade theory suggest it will not.
Short-Term Dynamics (0–12 months):
In the immediate aftermath of tariff implementation, supply chains are sticky. Importers cannot instantaneously identify alternative suppliers outside tariff borders, nor can they immediately re-shore production.
Consequently, they absorb the tariff burden and pass it to consumers. Tariff collections thus remain high because trade volumes have not yet adjusted. This is the “sugar high” phase we are currently experiencing in late 2025.
Medium-Term Dynamics (12–36 months):
Supply chain re-optimisation accelerates over time. Importers are strategically identifying alternatives. They are sourcing from nations such as Mexico, Vietnam, or India rather than relying on China. Production is shifting to lower-tariff jurisdictions or they are on-shoring specific inputs.
The Yale Budget Lab estimates the tariff regime will diminish real U.S. GDP by 0.6% in the long term. This decline is largely attributable to productivity losses resulting from supply-chain fragmentation and increased input costs for domestic manufacturers.
As supply chains move and production relocates, the tariff base consequently erodes. Collections decrease not because tariff rates have been reduced but because the volume of taxable transactions has contracted.
Demand Destruction:
Tariffs function as a regressive consumption tax.
By raising prices on imported goods and domestically-produced goods that compete with imports, they reduce real disposable income for households. Lower consumption implies lower corporate profits and lower wage pressures (as labor demand softens).
These dynamics, in turn, erode collections from Individual Income Tax and Corporate Income Tax.
The Congressional Budget Office projects that slower growth and diminished income tax collections will substantially negate the gross revenue generated from tariffs. The United States is effectively exchanging reliable income tax revenue for unpredictable tariff revenue, incurring the cost of reduced economic expansion.
The Legal Cliff: IEEPA and the Supreme Court
An existential contingent liability shadows the entire tariff regime.
Much of the tariff authority derives from executive orders invoking the International Emergency Economic Powers Act (IEEPA), a statute originally designed to address national security emergencies.
The U.S. Court of International Trade has already ruled portions of the tariff regime illegal, arguing they exceed presidential authority.
The case is now expedited to the Supreme Court.
Should the Supreme Court invalidate the IEEPA tariffs, a distinct possibility given the statute’s explicit language, 2 catastrophic outcomes will immediately materialise.
- Cessation of Collections: The revenue spigot closes immediately. Approximately $195 billion in FY 2025 tariff revenue evaporates.
- Refund Liability: The Treasury could face claims to refund “illegally collected” duties to importers. Estimates suggest roughly $90 billion of the $195 billion collected to date could be at risk.
A Supreme Court ruling against the administration would thus blow a $300 billion+ hole in the FY 2026–2027 budget, negating the entire deficit improvement and necessitating either emergency debt issuance or sudden spending cuts.
At Bancara, we assign a 35–40% probability to an adverse Supreme Court ruling within the next 18 months.
This is not a negligible risk.
It suggests that tariff revenue should be treated as a temporary, contingent revenue stream, not a permanent fixture of the fiscal baseline.
The Consumption Tax Transition
Conceptually, the pivot toward tariff revenue (a consumption tax) and away from income tax represents a fundamental restructuring of U.S. fiscal architecture.
This shift has profound distributional and efficiency consequences.
Distributional Impact: Tariffs are inherently regressive. They tax consumption proportionally to household expenditure. Lower-income households, which consume a higher share of their income, bear a disproportionate tax burden. This is politically volatile and economically inefficient.
Efficiency Impact: Tariffs distort relative prices, inducing resource misallocation. Consumers and businesses respond to tariff-induced price signals rather than underlying economic fundamentals, generating deadweight losses.
Permanence Risk: The OBBBA’s provisions are permanent or multi-year, suggesting a long-term reliance on tariff revenue. However, tariff policy is reversible by executive order or Congressional action, introducing uncertainty into the fiscal baseline.
This transition introduces basis risk for institutional investors holding long-duration liabilities. The sovereign borrower’s revenue base is shifting from the stability of income tax to the volatility of tariffs.
Meanwhile, the liabilities, comprising bonds and interest payments, maintain their fixed nominal value. This fundamental mismatch inherently generates convexity risk within long-duration Treasury holdings.
THE OBBBA REALITY—STRUCTURAL SPENDING AND THE TAX-CUT TRAP
The One Big Beautiful Bill Act, signed into law on 4 July 2025, represents the most significant structural fiscal legislation in the United States since the Tax Cuts and Jobs Act (2017). Yet unlike the TCJA, the OBBBA was pursued in an environment of high deficits, elevated debt-to-GDP ratios, and rising interest costs.
It is, in essence, a leveraging action undertaken by a highly leveraged borrower.
The Cost of Permanence: TCJA Extension and New Deductions
The OBBBA’s fiscal architecture rests on two pillars: the permanent extension of the 2017 Tax Cuts and Jobs Act individual provisions (which were set to expire at the end of 2025) and the introduction of new, relatively expensive tax deductions.
Permanent TCJA Extension:
The TCJA reduced individual income tax rates and nearly doubled the standard deduction. These provisions were designed as temporary, expiring after 2025, creating the assumption that revenues would automatically increase (“tax increases”) absent Congressional action. By permanently extending the TCJA, the OBBBA forgoes this revenue reset.
Compared to a baseline in which TCJA provisions expire, the permanent extension reduces the 10-year revenue baseline by approximately $2 trillion in gross terms.
New Tax Expenditures:
The OBBBA introduces several new deductions with unproven cost tracks:
- “No Tax on Tips”: A full deduction for tipped income through 2028. This creates perverse incentive structures for income reclassification. High-income professionals (hedge fund managers, consultants) may recharacterise compensation as “tips”, exploiting the deduction. The Joint Committee on Taxation (JCT) scores this at $250 billion over 10 years, but dynamic effects and enforcement challenges could materially widen the cost.
- “No Tax on Overtime”: A deduction for Federal Labor Standards Act (FLSA) overtime pay, scored at $150 billion over 10 years. This incentivises employers to shift to hourly wage structures and creates marginal incentives for overtime (versus salary + stock compensation), potentially lowering overall tax compliance.
- Senior Deduction: An additional $6,000 standard deduction for filers over age 65, scored at $75 billion over 10 years. As the aging population expands, this cost grows exponentially.
- Auto Loan Interest Deductibility: Restoration of deductibility for interest on auto loans, a subsidy to the auto finance sector, scored at $100 billion over 10 years.
Collectively, these new deductions add approximately $575 billion to the 10-year revenue loss, in addition to the TCJA permanent extension.
The Pay-For Problem: Implementation Risk and Political Headwinds
To offset these tax cuts, the OBBBA includes offsetting spending reductions. However, these “pay-fors” are politically fragile and face significant implementation risks.
Medicaid Reform:
The centerpiece of the offset is a restructuring of Medicaid eligibility and work requirements. The bill introduces strict work requirements for non-elderly adults and tightens asset tests, with a projected savings of $917 billion over 10 years.
However, implementation of such measures historically encounters delays, state-level litigation, and public resistance. The Congressional Budget Office assumes perfect implementation, a generous assumption rarely realised in practice.
We estimate a 40–50% haircut to the projected savings due to implementation failures and legal challenges.
Green Energy Rollback:
The bill repeals certain Inflation Reduction Act tax credits and grants, projected to save $180 billion over 10 years.
However, many of these projects have already broken ground or entered binding contracts with tax credit recipients, triggering legal claims for “vested rights” to the credits. Litigation over the retroactive clawback of tax credits is already underway, and the ultimate savings realisation remains highly uncertain.
A realistic scenario assumes 60–70% of the projected savings are realised, with the remainder tied up in litigation or grandfathering provisions.
CBO Scoring: The $4 Trillion Liability
The Congressional Budget Office formally scored the OBBBA as follows:
- Primary Deficit Impact (10-year, 2025–2034): +$3.4 trillion
- Interest Cost Impact (10-year, compounded): +$0.7 trillion to $1.2 trillion
- Total Impact on Debt: $4.1 trillion to $4.6 trillion
This scoring assumes baseline economic conditions (no recession, moderate growth), no implementation failures on the Medicaid reform, and full realisation of the green energy savings.
In a more adverse scenario (recession, litigation delays, behavioral responses), the total cost could exceed $5 trillion over 10 years.
The OBBBA thus locks in a structural deficit of approximately 6–7% of GDP for the foreseeable future.
This compares to a pre-pandemic structural deficit of approximately 3–4%, implying a permanent doubling of the baseline deficit burden.
DEBT DYNAMICS AND THE INTEREST RATE TRAP
The most underappreciated driver of fiscal unsustainability is not the deficit itself, but the interaction between debt service costs, economic growth, and the reversal of three decades of favorable interest rate dynamics.
Interest as the Dominant Expenditure: The Crowding-Out Effect
In Fiscal Year 2025, net interest costs reached $970 billion, equating to 3.1% of GDP and 11% of total federal revenues. This marks a pivotal moment in American fiscal history.
Interest payments have surpassed defense spending ($820 billion) and rival Medicare spending ($848 billion) as a line item. The U.S. government now spends more on servicing past debt than on national defense.
More ominously, the trajectory is sharply upward.
As the debt stock grows and the weighted average interest rate on both existing and new obligations increases, interest expenses will absorb a rising portion of the budget. The Congressional Budget Office projects that by 2035, net interest costs will reach 4.1% of GDP. This equates to approximately $1.8 trillion in nominal terms.
The Interest Cost Spiral: Crowding Out Discretionary Spending (2025–2035)
The above visualisation highlights a critical financial dynamic. Interest costs are projected to consume 28% of federal revenues by 2035. This development creates a significant crowding out effect. Discretionary spending, including infrastructure, research and development, and education, will face pressure to decrease as a share of GDP.
Eventually, mandatory spending programs such as Social Security will also feel this pressure to accommodate rising interest payments.
This is a fiscal death spiral in slow motion.
The “r > g” Trap: Explosive Debt Dynamics
The sustainability of sovereign debt critically depends on the relationship between the real interest rate on the debt (r) and the real growth rate of the economy (g). Specifically:
- If r < g: Even with a primary deficit, the debt-to-GDP ratio can stabilise because the economy grows faster than debt accumulates interest. This was the post-WWII norm for much of U.S. history.
- If r = g: The debt-to-GDP ratio is stable only if the primary budget is balanced. Any primary deficit will cause the ratio to drift upward.
- If r > g: The debt-to-GDP ratio is on an explosive trajectory regardless of the primary budget. Even with a primary surplus, the ratio can drift upward.
For most of the post-1980 era, the U.S. benefited from r < g.
Real interest rates were suppressed by financial repression (regulatory capital controls, reserve requirements, negative real yields), foreign demand for dollar assets (the savings glut), and the perceived safety of the U.S. Treasuries. This favorable condition allowed the U.S. to run persistent primary deficits without triggering a debt crisis.
That era has ended.
The weighted average interest rate on U.S. debt has risen from near-zero in 2022 to approximately 3.38% by late 2025 and is climbing. Nominal GDP growth (which includes inflation) is approximately 3.5–4.0%, but real GDP growth is only 2.0–2.5%.
When inflation moderates (a likely scenario as tariff impacts dissipate and demand normalizes), nominal growth could slip below real interest rates on an ex-post basis.
The Federal Reserve’s policy rate is stable near 3.50 to 3.75%. Long-end yields are approaching 4.50 to 5.00%. Real interest rates, nominal rates less expected inflation, are therefore positive and rising. The implied real rate for the 10-year is approximately 1.5 to 2.0%. This figure is nearing or exceeding real economic growth of 2.0 to 2.5%.
A scenario where the real interest rate is greater than economic growth is likely within 24 months.
If this occurs, the debt-to-GDP ratio rises mathematically, even if the primary budget is balanced.
Given that the U.S. currently runs a primary deficit of approximately 3% of GDP, an r > g regime would trigger explosive debt dynamics, potentially spurring a “debt spiral” in which rising debt ratios require higher interest rates, which further accelerate debt accumulation.
The Interest Cost Projection: Path Dependency and Compounding
The CBO’s baseline projection for interest costs shows net interest rising from $970 billion in FY 2025 to $1.8 trillion+ by FY 2035, assuming no recession and no further policy shocks.
However, the baseline assumes average interest rates on new debt approximating 4.0%.
In a scenario in which inflation remains elevated (tariff-driven) or geopolitical risk premiums widen, interest rates could settle 50–100 basis points higher, adding $500 billion to $1 trillion to the 10-year interest cost projection.
Moreover, the baseline assumes no recession.
In a recessionary scenario (which we assign a 40% probability within the 2026–2027 window, given the tightness of labor markets and potential demand destruction from tariffs), revenues would collapse, deficits would widen, and the Fed would likely cut rates.
However, if inflation remains sticky (due to tariffs or supply-side constraints), the Fed’s rate-cutting capacity would be constrained, creating a stagflationary environment in which growth stalls, deficits widen, but interest rates remain elevated.
This is the worst of all worlds for debt dynamics.
MARKET PLUMBING AND THE LIQUIDITY REGIME CHANGE
Perhaps the most immediate threat to the “shrinking deficit” narrative lies not in the fiscal arithmetic, but in the market mechanics that support the refinancing of the U.S. debt stock.
Even if the deficit temporarily narrows, the Treasury must refinance trillions of dollars in maturing debt.
The buyer base for this debt is undergoing a seismic and irreversible shift.
The Japanese Exodus: The Carry Trade Unwind
For three decades, Japan has been the most reliable and price-insensitive buyer of U.S. Treasuries, absorbing persistent U.S. current account deficits. Japanese banks, life insurers, pension funds, and the Bank of Japan itself accumulated over $1.1 trillion in U.S. Treasury holdings by 2025.
That relationship fundamentally fractured in December 2025.
Governor Kazuo Ueda oversaw the Bank of Japan’s decision to elevate its policy rate to 0.75%, reaching a level not observed since 1995.
Simultaneously, 10-year Japanese Government Bond (JGB) yields breached 2%, a 26-year high.
These moves were undertaken to stabilise the Japanese Yen, which had weakened structurally against the dollar, and to combat domestic inflation.
The Carry Trade Unwind:
The traditional “carry trade” involved Japanese institutional investors borrowing cheaply in Yen (at near-zero rates) and investing in higher-yielding assets abroad, particularly U.S. Treasuries.
This trade’s economic viability depended on two critical factors: a substantial yield differential between Treasury and JGB yields, and a stable or appreciating Yen to mitigate currency losses upon repatriation.
With the BoJ hiking and JGB yields climbing, the yield differential has collapsed.
A Japanese investor can now achieve 1.5–2.0% real returns domestically in JGBs without taking on currency risk or paying expensive hedging costs. The incentive for holding Treasuries has vanished given that they currently yield only 2.0-2.5% real returns after accounting for hedging costs.
The Data:
Treasury International Capital (TIC) data for late 2025 shows Japanese investors transitioning from net buyers to net sellers of U.S. Treasuries.
The flow reversal is estimated at $20+ billion per quarter.
Should this acceleration continue, perhaps spurred by further Bank of Japan rate increases or a stabilising Yen, the capital outflow could surpass $100 billion each quarter.
This represents a substantial supply shock to the long-dated U.S. Treasury market.
China’s Secular Divestment: Structural Supply, Not Cyclical Demand
Simultaneously, China continues its multi-year strategy of diversifying away from U.S. dollar assets.
Chinese Treasury holdings have fallen from a peak of over $1.3 trillion (circa 2011) to approximately $688 billion by October 2025.
This selling is driven by geopolitical risk management (U.S.-China tensions), the need to defend the Chinese Yuan, and domestic capital requirements.
This represents a fundamental structural transition, not merely a cyclical fluctuation.
China’s involvement with Treasuries has fundamentally shifted from peripheral participation to becoming a structural net seller. This strategic move involves diversification into alternative assets such as gold, bilateral swap agreements, and commodity-denominated reserves.
The flow from China will not reverse absent a dramatic geopolitical détente.
The Demand Void: Who Buys Now?
The exit of Japan and China leaves a demand void.
Historically, these two countries absorbed the current account deficits of the U.S., effectively funding the federal government’s spending in excess of revenues. Their withdrawal creates a vacuum that must be filled by alternative buyers.
Domestic Buyers (Households, Mutual Funds, Banks):
U.S. domestic financial institutions can absorb some supply, but they are price-sensitive.
As Treasury yields ascend relative to comparable returns from equities, corporate debt, and global sovereign obligations, the demand for Treasuries exhibits price elasticity.
Domestic demand cannot replace the price-insensitive demand previously supplied by Japanese life insurers and the Bank of Japan.
Hedge Funds and Arbitrageurs:
U.S. hedge funds and financial intermediaries have increased Treasury holdings, but these are carry trades (funding with short-term repo or basis trades). They are inherently unstable and subject to rapid unwinding if funding conditions tighten.
The Federal Reserve’s “Not-QE”:
In the absence of foreign demand, the Federal Reserve has stepped back into the market.
In December 2025, the New York Federal Reserve initiated “Reserve Management Purchases”. This program involves acquiring $40 billion in Treasury bills monthly. The stated objective is maintaining ample banking system reserves.
The Fed insists this is not Quantitative Easing.
The distinction, the Fed argues, is that RMP targets only bills (short-term debt) and is presented as a technical adjustment, not a monetary policy tool.
However, functionally and economically, the RMP is indistinguishable from QE. By absorbing $480 billion of annual T-bill issuance, the Fed is preventing short-term rates from spiking due to supply oversupply. This suppresses the front end of the curve but leaves the long end (coupon securities) exposed to market forces.
The Curve Dynamics:
This creates a structural steepening bias.
The Fed anchors short-term rates via RMP.
Meanwhile, the absence of Japanese and Chinese demand for longer-duration paper unmoors the long end.
The outcome is a Bear Steepener.
This regime sees long-term yields ascend more rapidly than short-term yields. This action tightens financial conditions for the real economy, impacting mortgages and corporate capital expenditure, even while the Federal Reserve implements rate cuts.
The Issuance Strategy Pivot: Bill Reliance and Duration Avoidance
Treasury Secretary Scott Bessent and the Treasury’s management have responded to this difficult environment by fundamentally altering the debt issuance strategy.
Bill Reliance: The share of T-bills in the Treasury’s outstanding debt has increased to over 20%, the highest level in decades. T-bills are short-dated (3–12 months), easier to sell, and require lower yields than longer-duration paper.
However, this creates acute refinancing risk.
If short-term interest rates spike (due to an inflation shock, a Fed pivot, or a financial system stress event), the entire T-bill portfolio must be rolled over at much higher rates, explosively accelerating interest costs.
Coupon Constraint: Auction sizes for 10-year and 30-year bonds have been held steady rather than expanded, an implicit admission that the market cannot easily digest more duration. The Treasury is effectively trying to minimise the supply of longer-term debt, hoping to avoid a failed auction or a severe tail (spread) widening.
The Risk: This strategy reduces immediate interest costs (as short-term yields are lower than long-term yields, assuming an upward-sloping curve) but maximises rollover risk. If inflation respikes and the Fed is forced to hike rates, the cost of the entire debt stack reprices rapidly. This strategy is predicated on a favorable trajectory for interest rates.
For a sovereign borrower with limited policy maneuverability, this constitutes a precarious gamble.
SCENARIOS AND MACRO IMPLICATIONS (2026–2035)
Considering the volatility impacting key inputs such as tariff legality, foreign capital flows, inflation, and Federal Reserve policy, we have developed 3 credible scenarios for the U.S. fiscal trajectory over the next 10 years.
Scenario A: Base Case—”The Fiscal Grind” (Probability: 60%)
Mechanism:
The deficit narrowing of late 2025 proves transient, as predicted. By mid-2026, the tariff “sugar high” fades as supply chains re-optimise and trade diversion accelerates.
Simultaneously, the OBBBA tax cuts begin to erode income tax receipts. The deficit stabilises at a high structural plateau of approximately $1.8–$2.0 trillion annually, or 6–7% of GDP.
Treasury Market Dynamics:
The Federal Reserve continues its RMP program indefinitely, effectively monetising T-bill issuance and anchoring the front end of the curve. Japan executes a slow, orderly exit from Treasuries, with flows declining by $15–$25 billion per quarter.
Domestic and hedge fund demand absorbs the residual supply, but at higher yields. The 10-year Treasury yield settles in the 4.25–4.75% range, a level substantially above historical averages.
Debt Dynamics:
The debt-to-GDP ratio rises structurally from the current 124% to approximately 145–150% by 2035. Net interest costs reach $1.8 trillion, consuming 25–28% of federal revenues. The primary deficit remains stuck near 3% of GDP, insufficient to stabilise the debt ratio given the interest rate environment.
Real Economy Impact:
Equities grind higher in nominal terms due to inflation, but real returns are compressed by sticky inflation (2.5–3.0% annually) and higher discount rates for long-duration growth stocks.
Corporate profit margins face pressure from tariff-related input cost inflation. Unemployment remains low (3.5–4.5%) due to demographics and labor supply constraints, but wage growth fails to keep pace with inflation, eroding real income growth.
Verdict: Slow, inexorable deterioration of U.S. credit metrics and investor purchasing power. No acute “Minsky Moment” or default scenario, but a corrosive fiscal trajectory that gradually shifts global capital allocation away from dollar-denominated assets.
Scenario B: Bear Case—”The Bond Vigilante Strike” (Probability: 25%)
Trigger:
Two major shocks are emerging.
First, the Supreme Court’s decision to invalidate the IEEPA tariffs mandates substantial refunds and reduces revenue by $200 billion to $300 billion.
Second, Japanese repatriation is accelerating due to either a further Bank of Japan rate increase or a spike in Japanese Government Bond yields, which introduces a sudden supply shock to the Treasury market.
Market Dynamics:
A “failed auction” occurs in the 20-year or 30-year tenor. Primary dealers refuse to take down supply at prevailing yields. The bid-to-cover ratio collapses. The tail (spread between the auction yield and when-issued yields) explodes by 50–100 basis points.
In response, the 10-year Treasury yield spikes to 5.5–6.0%. The long end of the curve detaches from the Fed’s policy rate, signaling a loss of confidence in the Treasury’s creditworthiness. Mortgage rates jump to 7.5–8.0%, crushing residential real estate demand. Corporate bond spreads widen sharply, raising the cost of capital for the real economy.
Fed Response:
The Federal Reserve is forced to abandon the fiction of “RMP” and implement explicit Yield Curve Control (YCC), committing to cap the 10-year yield at a specific level (e.g., 5.0%).
This constitutes a clear admission of fiscal dominance. The Federal Reserve has effectively ceded its independence and become subservient to the Treasury Department.
Currency and Capital Flight:
The dollar index (DXY), already under pressure from Fed rate cuts, falls toward 90 (from a recent 102). This triggers capital flight into alternative reserve currencies (Euro, Swiss Franc, Sterling) and hard assets (gold, commodities). Foreign central banks accelerate diversification away from dollar reserves, creating a vicious cycle of currency weakness and rising import costs.
Verdict: A stagflationary crisis and a loss of fiscal sovereignty. The U.S. enters a debt spiral requiring either explicit debt restructuring or hyperinflationary policy to erode real debt burdens.
Scenario C: Bull Case—”The Productivity Miracle” (Probability: 15%)
Mechanism:
The deregulation and pro-growth provisions of the OBBBA, combined with a productivity acceleration driven by AI adoption and capital formation, trigger a multi-year growth surge. Real GDP growth accelerates to 3.0–3.5% annually, echoing the late 1990s and early 2000s.
Debt Dynamics:
With nominal GDP growth exceeding interest rate growth (r < g returns), the debt-to-GDP ratio stabilises despite persistent primary deficits. The denominator effect (rising nominal GDP) masks the numerator effect (rising debt stock). Interest costs remain elevated in nominal terms but shrink as a share of revenues due to robust income tax growth.
Treasury Market:
Global capital floods back into U.S. equities and Treasuries as a percent-of-portfolio allocation, driven by the growth differential between the U.S. and other developed economies. The 10-year yield stabilises at 4.0–4.25%, a level that compensates for real growth. The Fed’s RMP is phased out as market demand returns.
Verdict: The U.S. grows its way out of the fiscal trap. Debt ratios decline in the 2030s. The structural challenges of demographics (aging Baby Boomers) and entitlements are deferred by growth, not resolved.
THE DURABILITY VERDICT
The headline question of this dossier is whether the U.S. federal deficit reduction can endure.
The unequivocal answer is no.
This present improvement will only persist until mid-2026 before a reversal.
The recent narrowing of the deficit in late 2025 is the result of temporary factors. These include calendar-driven timing shifts in benefit payments totaling $72 billion. One-time IRA grant comparisons contributed $17 billion. Discretionary spending cuts also played a part, though these are projected to expire within 12 to 18 months. These elements have afforded the Treasury a temporary illusion of stability.
However, they have failed to change the fundamental structural deficit.
The OBBBA’s enactment in mid-2025 has established a structural deficit minimum of approximately $1.7 to $1.8 trillion.
Simultaneously, the erosion of the global savings surplus, marked by Japan’s withdrawal from the carry trade and China’s ongoing diversification, has eliminated the cap on interest rates.
The U.S. is now financing a permanent tax cut and an expanding entitlement state using volatile consumption taxes (tariffs) and short-term debt, all while its principal creditors are leaving the table.
The Federal Reserve’s RMP program is the critical backstop preventing an immediate crisis, but it is also a harbinger of fiscal dominance. The Fed is slowly being captured by the Treasury’s refinancing needs, a dynamic that historically leads to stagflationary outcomes and erosion of central bank credibility.
At Bancara, we assess the probability of a structural reversion to deficits of $1.7–$2.0 trillion by late 2026 at 75–80%. We assign a 25–35% probability of a more acute shock (tariff Supreme Court ruling, foreign creditor flight) triggering a Treasury market dislocation within 18–24 months.
POSITIONING FOR INSTITUTIONAL INVESTORS
Given the above analysis, Bancara recommends the following positioning for ultra-high-net-worth and institutional portfolios:
Fixed Income:
- Reduce duration exposure to U.S. Treasuries beyond the 5-year tenor. The long end (10-30 years) faces structural headwinds from foreign divestment and Fed curve control.
- Overweight short-duration T-bills (3–6 months) to hedge near-term refinancing risk.
- Diversify into non-dollar government bonds (select Swiss, Norwegian, Singapore sovereigns) to reduce currency concentration risk.
Equities:
- Underweight long-duration, high-multiple growth stocks, which face valuation pressure from rising discount rates.
- Overweight value and dividend-yielding equities with pricing power (e.g., those benefiting from tariff protection or supply-chain monopolies).
- Consider reducing equity exposure to sectors dependent on low interest rates (residential real estate, utilities, unprofitable growth tech).
Alternatives:
- Increase real asset allocation (commodities, inflation-linked bonds, gold) to hedge stagflation risk.
- Consider opportunistic illiquidity premia from stressed fixed-income dislocations in the 2026–2027 window.
Currency:
- Reduce dollar concentration. Diversify into hard currencies (Swiss Franc, Singapore Dollar) or hard assets.
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