Analysis of the Impact of Expanding U.S. Fiscal Deficits on the U.S. Treasury Yield Curve and the Federal Reserve's 2025 Interest Rate Policy

Based on the data and analysis I have collected, I now present a comprehensive research report.

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According to the latest data from the U.S. Department of the Treasury, the federal budget deficit reached

in December 2025, a record high for that month, representing a 67% year-on-year increase [1]. This figure significantly exceeded market expectations, mainly affected by two factors:

• Expenditure Side
  : Government spending saw record growth, with approximately $32 billion in January 2026 benefit payments advanced to December due to the New Year weekend
• Revenue Side
  : Although tariff revenue grew significantly (customs revenue reached $27.9 billion in December, up from $6.8 billion in the same period in 2024), part of this growth was offset by timing adjustments to other revenues

After adjustment, the actual deficit in December 2025 was $112 billion, down 11% from December 2024, but fiscal pressures have not been fundamentally alleviated [1].

According to analysis from the Committee for a Responsible Federal Budget (CRFB), the U.S. fiscal trajectory faces severe challenges:

Indicator	2025	2035 (Baseline Scenario)	2035 (Alternative Scenario)
Debt-to-GDP Ratio	~124%	120%	134%
Annual Deficit	$1.775 trillion	$2.6 trillion	—
Interest Payments on National Debt	$718 billion	$836 billion	—

CRFB’s alternative scenario assumes that most unlawful tariffs are revoked, temporary provisions of the OBBBA are made permanent, and Treasury yields remain at current levels above the Congressional Budget Office (CBO) baseline set earlier this year [2].

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In 2025, the U.S. Department of the Treasury faces approximately

in debt refinancing pressure. This scale is equivalent to:

• ~25% of U.S. GDP
• Far exceeding 2024’s refinancing demand

The Treasury Department has announced that it will raise funds through regular auctions:

• 3-year notes: $58 billion
• 10-year notes: $42 billion
• 30-year bonds: $25 billion
• Total quarterly financing scale:
  $125 billion

Market data shows that foreign investor participation continues to decline:

Indicator	April 2024	April 2025	Trend
Share of Foreign Investors	72%	50%	↓22 percentage points
Bid-to-Cover Ratio	2.5x	1.85x	↓26%

The stability of foreign holdings of U.S. Treasuries has been called into question. Although net foreign purchases reached $472 billion as of September 2025, historical experience shows that foreign holdings may fluctuate with policy uncertainty during trade wars [3].

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The U.S. Treasury market experienced a historic shift in yield curve shape in 2024:

Time Point	2-Year Yield	10-Year Yield	2s10s Spread	Curve Shape
Mid-2024	~5.00%	~4.50%	-50bps	Deep Inversion (Historical Extreme)
End of 2024	~4.22%	~4.57%	+35bps	Beginning to Steepen
End of 2025	~3.46%	~4.17%	+69bps	Normal Steepening

The 2-year yield fell by approximately

over the full year, while the 10-year yield fell by approximately , causing the 2s10s spread to steepen by 35 basis points over the year, with a cumulative steepening of 179 basis points since mid-2023 [4][5].

1. The Federal Reserve launched an interest rate cut cycle (cumulative 175 basis point cuts starting from September 2024)
2. Market expectations for accommodative monetary policy
3. Relief of pressure in the short-term financing market (the Federal Reserve restarted its short-term Treasury bill purchase program)

1. Expanding fiscal deficits increase bond supply pressure
2. Inflation expectations remain above the Federal Reserve’s 2% target
3. Term premium rises due to increased uncertainty

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The Federal Reserve cut interest rates consecutively at the last three FOMC meetings in 2025:

Meeting Date	Rate Cut Magnitude	Federal Funds Rate Range	Vote Result
September 2025	25bps	4.00%-4.25%	9-2
November 2025	25bps	3.75%-4.00%	9-2
December 2025	25bps	3.50%-3.75%	9-3

The 9-3 vote result at the December meeting was the

, indicating growing divisions within the FOMC [6].

According to the December 2025 FOMC meeting minutes and dot plot [6][7]:

Time Node	Interest Rate Forecast (Median)	Forecast Range
End of 2025	3.50%-3.75%	Achieved
End of 2026	3.00%-3.25%	Probable 1 rate cut
End of 2027	~2.75%	1 additional rate cut
Long-Run Neutral Interest Rate	~3.00%	—

Officials have significant disagreements on the 2026 interest rate path:

• Hawkish Officials
  : Believe interest rates should be maintained for a longer period, with the ultimate policy rate possibly reaching 3.875%
• Dovish Officials
  : Prefer more aggressive rate cuts, with the ultimate policy rate possibly falling to 2.625%

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Expanding Fiscal Deficits
    │
    ├──► Increased Treasury bond issuances → Higher supply → Upward pressure on yields
    │
    ├──► Current account deficit → U.S. dollar under pressure → Capital outflow risk
    │
    └──► Increased interest payments → Restricted fiscal space → Expectations of future spending cuts or tax hikes

1. Inflation Transmission
   : Fiscal stimulus (tax cuts, government spending) boosts aggregate demand, supporting sticky inflation
2. Confidence Effect
   : Investor concerns about fiscal sustainability may push up term premiums
3. Policy Coordination
   : Financing needs of the Treasury Department and the Federal Reserve may lead to policy conflicts

According to forecasts from institutions such as Continuum Economics [5]:

Maturity	2026 Forecast
2-Year	3.35%-3.50% (falls first then rebounds)
10-Year	Fluctuates within the 4.00%-4.25% range
2s10s Spread	90-100bps (further steepening)
30-Year	May break above 5%

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• First Half of 2026
  : The Federal Reserve may pause rate cuts to observe economic data
• Second Half of 2026
  : After the economic soft landing is confirmed, 1-2 additional rate cuts will be implemented
• Year-End Federal Funds Rate
  : 3.00%-3.25%

• Core PCE inflation is slightly above 2%
• The job market remains resilient
• Fiscal policy is moderately expansionary

• If the U.S. economy enters a mild recession, the Federal Reserve may cut interest rates sharply
• The federal funds rate may fall to
  2.00%-2.50%
• 2-year and 10-year yields will decline more rapidly

Factor	Direction	Weight
Inflation pressure from tariff policies	↑ Yields / Slow rate cuts	High
Expanding fiscal deficits	↑ Yields	High
Slowing labor market	↓ Yields / Promote rate cuts	Medium
Appointment of a new Federal Reserve Chair	Uncertainty	Medium
Geopolitical risks	↓ Yields / Promote rate cuts	Low

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1. Yield Curve Steepening Trade
   : The current 2s10s spread is about 69bps, which may further widen to 90-100bps, making curve steepening strategies suitable

2. Relative Value of Short-Term Bonds
   : The 2-year yield has fully priced in rate cut expectations, reducing its attractiveness relative to long-term bonds

3. Credit Spread Risk
   : Fiscal concerns may push up credit spreads, putting pressure on high-yield bonds

• Debt Ceiling Negotiations
  (expected in summer 2025): May trigger volatility in the short-term financing market
• Credit Rating Downgrade
  : If the fiscal trajectory deteriorates, it may trigger actions by rating agencies
• Behavior of Foreign Holders
  : If foreign investors continue to reduce their holdings, yields will be pushed higher

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[1] Reuters - “US posts record $145 billion December deficit as outlays jumped” (https://finance.yahoo.com/news/us-posts-record-145-billion-190716149.html)

[2] CRFB - “Top 13 Fiscal Charts of 2025” (https://www.crfb.org/blogs/top-13-fiscal-charts-2025)

[3] CFR - “Trade, Tariffs, and Treasuries: The Hidden Cost of Trump’s Protectionism” (https://www.cfr.org/article/trade-tariffs-and-treasuries-hidden-cost-trumps-protectionism)

[4] CNBC - “Fed minutes December 2025” (https://www.cnbc.com/2025/12/30/fed-minutes-december-2025.html)

[5] Continuum Economics - “DM Rates Outlook: 2026 Yield Curve Steepening Before 2027 Flattening” (https://continuumeconomics.com/a/7d576bd6/dm-rates-outlook-2026-yield-curve-steepening-before-2027-flattening)

[6] Congress.gov - “Federal Reserve Cuts Interest Rates in Late 2025” (https://www.congress.gov/crs-product/IN12635)

[7] iShares - “Fed Outlook 2026: Rate Forecasts and Fixed Income” (https://www.ishares.com/us/insights/fed-outlook-2026-interest-rate-forecast)

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Jinling AI Financial Database, compiled from public market data

Report Generation Date: January 14, 2026