U.S. Treasuries: Balancing income and diversification opportunities with policy risks

U.S. Treasury prices don’t move on headlines alone; they respond to a steady tug-of-war among Federal Reserve policy, inflation, growth expectations, and bond supply. Right now, valuations appear to reasonably reflect those core forces, even as investors keep a close eye on deficit spending and what it could mean for future issuance. At the same time, Treasuries still earn their place in diversified portfolios by combining income potential with a historically distinct diversification profile.

For investors building resilient portfolios – whether you’re focused on stability, liquidity, or long-term outcomes - Treasuries can serve more than one role at once. They can help anchor riskier allocations during volatile periods, and they can also help investors pursue reliable income without taking on corporate credit exposure. “Treasuries offer reliable, high-quality income, while adding a unique source of diversification to portfolios,” says Bill Merz, head of capital markets research with U.S. Bank Asset Management Group.

What moves Treasury yields?

Today, Treasury yields span roughly 3.3 %-4.9%, depending on maturity, creating meaningful income opportunities. Even with explicit U.S government backing, Treasury prices can still fluctuate before maturity and those price moves can matter for investors who rebalance, harvest gains, or manage interest rate risk. Because bond prices move inversely to yields, even modest rate changes can translate into notable price swings, especially in longer maturities.

We assess the ‘fair value’ of various U.S. Treasuries using four fundamentals: current and expected Federal Reserve policy (including balance sheet activity), inflation and investor inflation expectations, economic growth views and expected Treasury supply tied to federal government deficit spending. ¹ That framework matters because it pushes the conversation beyond “rates up or down” and into which force is doing the driving at any given time. It also helps investors separate near-term market noise from the longer arcs of policy, inflation, and growth that tend to shape yields over time.

A four-factor “fair value” lens for Treasuries

This fair value approach suggests that today’s Treasury prices compensate investors for key risks—including Fed expectations, inflation, growth considerations, supply dynamics, and diversification benefits. “Our proprietary fair value model indicates current Treasury prices fairly compensate investors for risks, including Fed policy expectations, inflation and growth considerations, bond supply dynamics and the portfolio diversification benefits of Treasuries,” Merz notes. In that model, Fed policy rate expectations account for about three-quarters of the fair value yield, making them the dominant long-term driver in this framework.

Still, the market rarely follows a single storyline for long, and other forces can add lift—or pressure—at the margin. When investors expect the Fed to cut short-term interest rates, yields often fall as investors anticipate reduced reinvestment opportunities in cash-like instruments. At the same time, new issuance tied to deficit funding and the diversification relationship versus equities can influence where yields ultimately settle.

The Fed’s role: Interest rates, expectations, and the balance sheet

The Federal Reserve shapes Treasury yields through two channels: the policy rate and the size of its balance sheet. By setting the federal funds rate – an overnight inter-bank funding rate – the Fed establishes a baseline that most directly affects short-term Treasury yields. Longer-term yields then respond as investors weigh whether to reinvest in short maturities or lock in higher longer-maturity income.

The Fed reduced its target short-term rate by 1.75% across 2024 and 2025, bringing the target range to 3.50-3.75%. Current interest rate pricing implies investors expect two additional 0.25% cuts in 2026, which can help anchor long-term bond yields when markets anticipate declining short-term income. Our propriety analysis suggests 10-year Treasury yields reasonably compensate investors for Fed policy expectations.

The Fed also influences Treasury yields by buying and selling Treasuries for its own account. The Fed recently shifted from reducing its Treasury holdings to buying about $40 billion of short-term Treasury bills each month, primarily to support smooth funding-markets functioning. Because that purchase activity means private investors absorb less aggregate supply, it can help steady yields at the margin.

Deficit spending: Real risk factor, but not the main driver yet

America’s fiscal trajectory remains a focus for investors, especially with the federal deficit hovering near 6% of GDP. That backdrop has generated warnings from ratings agencies, including Moody’s downgrade of U.S. debt in 2025, following S&P in 2011 and Fitch in 2023. Financial markets, however, reacted only mildly, with U.S. bonds performing largely in line with those of other developed economies during the same period. “We do not see strong evidence of the U.S. fiscal situation heavily influencing bond yields right now based on our calculations, but we must monitor government, economic and market data for signs of change,” says Merz.

Policy choices can also shift the deficit path, including tax and tariff changes, while the Congressional Budget Office projects elevated deficits over the next decade as spending exceeds tariff and tax revenue. Recently, the Treasury relied on higher short-term Treasury bill issuance to fund government, which helped prevent increased supply from lifting intermediate and long-term yields. Treasury stated in November 2025 that it plans to continue this policy, keeping medium and long-term bond auction sizes stable for the next several quarters. Eventually, ongoing deficit spending could require greater medium and long-term bond issuance.

What influences global demand for Treasuries?

Despite recurring headlines about foreign investors stepping away, data tells a different story. International buyers increased their Treasury holdings by more than $500 billion from the November 2024 presidential election through October 2025. This demand provides foundational support even when sentiment swings.

Concerns of a foreign investors buying “strike”, which could sharply lift yields are unrealized. “There is no evidence of this from bond price or yield yet,” says Merz. That doesn’t eliminate risk, but it does suggest investors separate scenario planning from market evidence.

Auction results provide another real-time window into demand. Recent auction outcomes are only slightly weaker than long-run averages. Typical indicators such as auction “tails” (prices relative to prior day closing levels), bid-to-cover ratios (bids received relative to bonds offered), and bid/ask spreads (the difference between a seller’s “ask” price and a buyer’s “bid” price) evidence generally normal bond market functioning. “Domestic demand fluctuated over the past couple years on investor inflation and deficit concerns, but Treasury auction results are near-normal,” says Merz. Additionally, government agencies proposed regulatory changes that could unlock additional capacity for financial institution Treasury holdings.

Why Treasuries still matter in diversified portfolios

In a portfolio context, Treasuries can help investors pursue steadier income while dampening volatility in riskier asset prices. Investors seeking more consistent returns can benefit from larger high-quality bond allocations, while even more risk-tolerant investors can use Treasuries as a stabilizing counterweight. Because high-quality bonds often move differently than stocks and other higher-risk assets, Treasuries can support diversification aimed at managing overall portfolio volatility.

U.S. Treasuries remain a core holding for diversified portfolios. The market has, to date, adapted to higher issuance by way of broader participation and regulatory support. Today’s yields offer meaningful income opportunities that fairly compensate for policy expectations, supply, inflation, and diversification properties. We remain vigilant in our monitoring of risk factors such as shifting Fed policy, new legislation, ongoing deficit spending and investor sentiment.