US yield curve steepening, Fed–Treasury coordination debate, and shifting liquidity conditions for risk assets

The U.S. Treasury market remains under intense strain amid an unprecedented confluence of fiscal pressures, shifting global reserve dynamics, and evolving market structure reforms. As the United States navigates a historic debt rollover exceeding $9 trillion, the interplay between elevated deficits, foreign official portfolio reallocations, and liquidity fragmentation continues to challenge market functioning and policy frameworks in early 2026.

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Persistent Fiscal Stress and Intensified IMF Warnings

The fiscal outlook has deteriorated further, with the International Monetary Fund (IMF) renewing urgent calls for Washington to enact meaningful spending cuts to avert a debt crisis. The IMF’s recent statements emphasize that U.S. federal deficits are projected to remain persistently elevated at 7–8% of GDP in the coming years, reinforcing concerns that unchecked borrowing will escalate debt servicing costs and imperil investor confidence.

These warnings echo earlier analyses by the Congressional Budget Office (CBO) forecasting a FY2026 deficit approaching $1.9 trillion, fueled by reduced tariff revenues following Supreme Court rulings and surging interest payments now expected to top $280 billion by 2026. The IMF underscores that without credible fiscal consolidation, refinancing risk will rise, potentially triggering market volatility amid a fragile global economy.

A recent IMF policy note cautions that Washington’s borrowing trajectory is “dangerous,” urging policymakers to curtail spending expansions, especially in defense and entitlement programs, to stabilize debt dynamics before reaching record debt-to-GDP levels. The IMF’s intervention reflects heightened global concern over U.S. fiscal sustainability as a pillar of international financial stability.

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Shifting Global Reserve Management Tightens Dollar Liquidity

Compounding domestic fiscal challenges, key foreign official holders are actively recalibrating their reserve portfolios away from U.S. dollar assets, tightening global dollar liquidity and complicating Treasury demand. The European Central Bank (ECB) has accelerated its reduction of U.S. dollar reserves in favor of Japanese yen and other currencies, with recent data showing a multi-percentage point drop in dollar holdings in early 2026.

This trend follows significant reductions by the Reserve Bank of India (RBI), which cut its U.S. Treasury holdings by 18% in 2025 and is scheduled to wind down liquidity support programs after March 2026. Collectively, these shifts signal a broader move by major central banks to diversify reserves amid concerns over U.S. economic policy unpredictability and dollar volatility.

According to Jean-Baptiste Berthon of Amundi, in a recent SUERF Policy Note analyzing global liquidity conditions, these foreign official adjustments are emblematic of a “journey of global liquidity” moving towards multipolar reserve currency regimes and more fragmented capital flows. This recalibration intensifies the pressure on U.S. debt markets to absorb record issuance in an environment of constrained dollar liquidity.

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Treasury Market Dynamics: Yield Curve Steepening and Liquidity Fragmentation

Market manifestations of these fiscal and external pressures have become increasingly acute:

• The U.S. Treasury yield curve has steepened further, with the 10-year yield oscillating around 4.05%, reflecting rising inflation expectations and elevated refinancing risks amid heavy issuance.

• Auction bid-to-cover ratios remain muted, signaling investor caution even as issuance volume hits historic highs.

• Bid-ask spreads have widened substantially, attributed to reduced dealer intermediation constrained by regulatory frameworks like the Liquidity Coverage Ratio (LCR), which limit balance sheet usage for market-making.

• Intraday volatility has surged, underscoring fragile liquidity conditions exacerbated by the reduction of key foreign official buyers and the RBI’s liquidity program wind-down.

• Spillover effects are emerging in credit-sensitive sectors, particularly AI-related corporates and cryptocurrencies, where early credit stress signals raise concerns about systemic vulnerabilities linked to Treasury market dislocations.

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Federal Reserve Tactical Interventions and Policy Debates

In response, the Federal Reserve continues tactical balance sheet expansions as a stopgap measure to alleviate stress:

• Monthly Treasury bill purchases of around $55 billion persist to manage peak refunding needs expected through mid-2026.

• Active repo market operations provide critical short-term liquidity and collateral support, helping stabilize daily funding conditions.

However, these interventions fuel ongoing policy debates about the balance between market accommodation and inflation risks. Former Fed Governor Kevin Warsh warns that prolonged balance sheet expansions without a formal Fed–Treasury coordination framework risk reigniting inflation and distorting markets. Warsh advocates for enhanced issuance transparency and more stable auction mechanics to reduce rollover risk while maintaining inflation discipline.

Conversely, proponents of the Brookings Institution’s ample reserves framework, including economist Chris Hughes and New York Fed EVP Marcos Remache, argue that maintaining an ample reserves regime is indispensable for Treasury market functioning amid extraordinary fiscal demands. Remache recently noted, “An ample reserves regime is critical to preserving market liquidity and financial stability, especially given current global uncertainties.”

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Geopolitical Spending and the Global Debt Environment

Geopolitical ambitions remain a significant upside risk to issuance trajectories:

• Former President Donald Trump’s proposal to boost Pentagon spending to $1.5 trillion annually would substantially increase federal outlays and debt rollover pressures, heightening refinancing challenges in an already stressed market.

• Global sovereign debt reached a staggering $348 trillion in 2025, driven predominantly by fiscal deficits rather than private borrowing, escalating sovereign borrowing costs and intensifying capital flow volatility.

• The ECB’s February 2026 Quarterly Overview highlights how Eurozone monetary normalization and rising sovereign issuance spill over into U.S. Treasury market liquidity constraints.

• The Norges Bank Watch report underscores the mounting complexity of sovereign debt management worldwide and the urgent need for coordinated global monetary-fiscal strategies to mitigate systemic risks.

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Accelerating Market Structure Reforms and Technological Innovation

Efforts to enhance Treasury market resilience are gaining momentum:

• The Securities and Exchange Commission (SEC) remains on track to implement mandatory central clearing for Treasury cash and repo markets by December 31, 2026, and June 30, 2027, respectively. These reforms aim to improve transparency, reduce counterparty risk, and bolster liquidity.

• Pilot programs deploying blockchain and distributed ledger technology (DLT), inspired by UK successes, are underway to streamline issuance, settlement, and reduce reliance on constrained dealer intermediation.

• New liquidity-monitoring platforms now integrate auction results, Fed liquidity operations, and foreign official flow data, providing real-time insights essential for policymakers and market participants.

• The upcoming 2025 USD Liquid Indices Review by S&P Dow Jones Indices will recalibrate benchmark compositions to better reflect evolving liquidity and issuance patterns, influencing investor behavior and product design.

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Intensified Policy Discourse on Fed–Treasury Coordination and Monetary Frameworks

The complex interplay of fiscal stress, liquidity constraints, and inflation persistence has sharpened policy debates:

• Leading economists such as Kevin Warsh and Raghuram Rajan advocate a dual approach: uphold inflation anchoring through stable or slightly elevated policy rates while establishing a formal Fed–Treasury coordination framework to enhance issuance transparency and market stability.

• Rajan succinctly summarized the paradox: “Liquidity is abundant everywhere but inaccessible where it matters most,” highlighting regulatory and market structure barriers to usable market liquidity despite ample reserves.

• Federal Reserve leadership emphasizes the need to preserve an ample reserves regime that balances inflation control, financial stability, and central bank independence.

• The Brookings Institution's ample reserves framework continues to serve as a key blueprint for reconciling liquidity provision with inflation objectives and institutional autonomy.

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Systemic Risks and the Dollar’s Reserve Currency Status Under Pressure

Treasury market health remains critical to U.S. global economic leadership and the dollar’s reserve status:

• The Bank for International Settlements (BIS) warns that soaring sovereign debt limits central bank policy flexibility and fosters “zombie firms” that undermine economic dynamism.

• Bridgewater Associates founder Ray Dalio cautions that unchecked U.S. debt accumulation risks eroding the dollar’s reserve currency role, with declining foreign demand potentially driving up borrowing costs and diminishing geopolitical influence.

• These dynamics frame Treasury market pressures as both financial and strategic challenges amid an increasingly multipolar global order.

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Emerging Monetary Regime Challenges Amid the AI Economy

Advances in artificial intelligence are reshaping macroeconomic fundamentals and monetary policy considerations:

• Market participants are reassessing the neutral interest rate and inflation trajectories in light of AI-driven productivity gains and altered credit dynamics.

• Observers caution this may signal a silent monetary regime shift, necessitating novel policy tools and enhanced monitoring to navigate evolving economic conditions.

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Conclusion: Treasury Market at a Historic Crossroads Demands Vigilant Stewardship

The U.S. Treasury market stands at a pivotal juncture amid a historic $9 trillion-plus debt rollover, deteriorating fiscal fundamentals, delayed inflation normalization, and fragile liquidity exacerbated by shifting foreign official flows. The Federal Reserve’s tactical balance sheet expansions provide critical but temporary relief as debates over inflation risks, market distortions, and formal Fed–Treasury coordination intensify.

Record geopolitical spending ambitions and unprecedented global sovereign debt levels compound supply-demand challenges. Promising market structure reforms—including SEC clearing mandates and blockchain pilots—aim to enhance resilience but have yet to fully resolve systemic vulnerabilities.

In this volatile environment, vigilant monitoring of auction demand metrics, Federal Reserve liquidity operations, foreign official flows (notably ECB and India), credit stress in emerging sectors, legislative fiscal developments, FX volatility, clearing/DLT reforms, and international monetary-fiscal coordination is essential to safeguard the Treasury market’s foundational role in global finance and U.S. economic leadership.

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Key Monitoring Points

• Auction bid-to-cover ratios and demand metrics: To assess investor appetite amid heavy issuance
• Federal Reserve balance sheet guidance and repo operation frequency: Indicators of monetary accommodation and liquidity support
• Foreign official flows: Especially ECB dollar reserve adjustments, India’s Treasury holdings, and RBI liquidity policies
• Credit stress signals in AI-related corporate and cryptocurrency sectors: Early warnings of systemic risk spillovers
• Legislative developments on fiscal consolidation and defense spending: Determining future issuance trajectories
• FX market responses to commodity shocks and exchange rate policies: Impacting capital flow stability
• Progress on SEC central clearing requirements and blockchain/DLT integration: Foundations for long-term market resilience
• Global sovereign debt trends and international monetary-fiscal coordination initiatives: Framing systemic and policy risks

Policymakers, market participants, and global stakeholders must remain agile and collaborative to navigate the complex fiscal, monetary, and geopolitical dynamics shaping the future of U.S. government debt markets during this historic period of transformation.