(Bloomberg) -- Growth in the size of the US Treasury market is likely to keep upward pressure on yields even if the Federal Reserve starts cutting interest rates, in contrast to historical patterns, according to strategists at Barclays Plc.

Though unlikely to soar to levels much beyond 5%, Treasury yields “are likely to buck the historical trend of falling as the Fed’s easing cycle begins,” Barclays’ US rates research team led by Anshul Pradhan said in a report. 

That’s not only because large budget deficits and associated Treasury supply “are here to stay,” but also because the low sensitivity of long-term interest rates to deficit trends may become a thing of the past.

The various factors that have allowed Treasury yields to decline during periods of wide deficits and debt expansion “are likely to turn less supportive,” the analysts wrote. “As a result, historical analysis could very well be understating the sensitivity of interest rates to the worsening fiscal profile.”

The 10-year Treasury yield jumped to a six-month high near 4.75% in April as resilient US economic data prompted traders to pare expectations for Fed rate cuts this year. It was about 4.65% on Tuesday. The Barclays strategists expect it to stabilize in the 4.5% to 5% range over the coming year even as the Fed lowers its policy rate at least to 3.5%-3.75% and possibly by an additional half point. 

Under that scenario, the Treasury yield curve, “which has been inverted for almost two years now,” with long-maturity lower than short-maturity yields, “should return to its normal upward-sloping shape sooner than many expect.”

Treasury debt outstanding has more than doubled since 2016 to nearly $27 trillion. As a percentage of US GDP it’s on pace to continue to expand. This “tsunami of Treasuries will affect several key assumptions underpinning the fixed income markets,” the Barclays teams writes. 

Factors that are turning less supportive for the Treasury market according to the Barclays strategists include:

  • “Active fiscal policy” that raises the expected path of the Fed’s policy rate and therefore the expected return on cash
  • Upward pressure on term premium stemming from greater reliance on price-sensitive buyers, as well as from increases in rate volatility, correlation between stock and bond returns, and inflation risk premium

“The bottom line is that the Treasury universe has grown too large and investors need to factor the potential for increased bouts of illiquidity, poor functioning, and heightened volatility when thinking about valuations,” the strategists wrote.

As a benchmark for interest rates on mortgages and corporate debt, Treasury yields have the potential to drive up borrowing costs throughout the economy.

“Higher interest rate volatility and an increase in term premia are negatives for agency MBS and corporate credit spreads, particularly if accompanied by slowing growth,” said the bank.  

A companion report by Barclays strategists Jeffery Meli and Ajay Rajadhyaksha predicts the US budget deficit will remain wide irrespective of the outcome of the November elections.

With higher US yields posing risks to other global bond markets as they tend to move in sync, “any tremor in US Treasuries is likely to be felt far and wide,” they said. “And with the amount of Treasuries increasingly on offer, those tremors are likely to become more frequent.”

--With assistance from Charlie Zhu, Wenjin Lv, Neha D'silva and Tian Chen.

(Adds additional content from US rates strategists and context throughout.)

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