Insights into this week's US Treasury refunding: 3-, 10-, and 30-year overview.

Summary:

• Safe-haven demand will be scrutinized this week as the 3-, 10-, and 30-year US Treasury auctions take place with significantly lower yields following last week’s FOMC meeting and weak employment data. Yields have dropped to the lowest since December 2023 and investors will question the value at these levels, especially amid markets’ aggressive interest rate cut expectations as inflation remains at 3% and the U.S. economy is growing above 2%.
• Potential rising yields due to decreased indirect bidder demand. A decrease in demand from indirect bidders, who comprise over half of the demand at US Treasury auctions, could lead to rising yields across tenors. The July 30-year Treasury auction saw indirect bidder participation drop to 60.1%, causing a tail of 2.2 basis points. A similar drop this week could indicate that coupon supply might becoming hard for markets to digest amid substantial fiscal spending and the unwinding of the Japanese carry trade.

Safe-Haven Demand Under Scrutiny in This Week’s US Treasury Auctions.

The setup for this week’s 3-, 10-, and 30-year US Treasury auctions is particularly intriguing, given the significant drop in yields following last week’s FOMC meeting and weak employment data. Since the market opened last Wednesday ahead of the FOMC meeting, yields have fallen by 34 basis points for the 3-year, 27 basis points for the 10-year, and 28 basis points for the 30-year notes. If current pricing levels hold, these auctions will see the lowest yields since summer 2023.

A critical question is whether investors are inclined to extend their portfolio duration at these levels, considering the risk that the Federal Reserve might not implement the aggressive interest rate cuts currently priced into bond futures markets. SOFR futures contracts are anticipating roughly 110 basis points of rate cuts by the end of the year, with the first 50 basis point cut expected in September.

It’s essential to highlight that the recent substantial bond rally might have been driven by the unwinding of the Japanese carry trade. With the FOMC signaling imminent interest rate cuts, and the BOJ signaling for more hikes, the Japanese carry trade becomes less convenient. Hence, investors who borrowed in Japanese yen to invest in US dollar and euro-denominated securities might have reason to unwind their positions, leading to a notable appreciation in the yen and increased volatility, bolstering demand for safe-haven securities.

This week’s Treasury auctions will be a critical indicator of whether foreign investors are repatriating their funds. Indirect bidders, who make up more than half of the demand at US Treasury auctions, are a crucial component of investor demand. A sudden drop in indirect demand could result in a tail at the auction, potentially leading to a selloff in secondary markets.

We observed a similar scenario during the 30-year US Treasury auction in July, where indirect bidder participation dropped to 60.1%, the lowest since November 2022 and the second lowest since December 2021. This decline caused a tail of 2.2 basis points on the auction. However, an increase in direct bidders, reaching the highest level since December 2014, helped mitigate the impact.

At this week’s 10- and 30-year auctions, if demand from indirect investors declines, domestic investors and primary dealers will need to absorb the supply. Should direct investors also show a lack of interest, it could be an early indication that the recent selloff in risky assets is mainly due to the unwinding of the Japanese carry trade rather than weakened sentiment in the U.S. economy. This scenario suggests that the worst may be yet to come, as reduced foreign appetite for Treasuries could lead to higher yields in the long run, as previously analyzed.

What implications does this hold for bond markets?

The macroeconomic backdrop is favorable for US Treasury demand, with the economy slowing, the Federal Reserve tapering QT since June, and policymakers considering rate cuts.

However, the recent rally has significantly reduced yields, raising the question of whether investors will be willing to purchase these securities when the term premium remains negative and inflation is at 3% at the headline level and 3.3% at the core.

Last week, US Treasury yields broke below support at 4.18% and fell to 3.66%. If bidding metrics are strong at this week's 10-year US Treasury auction, yields may continue to decline, potentially breaking below 3.66% and finding strong support at 3.29%. Conversely, if bidding metrics are weak, yields could rise and face resistance at 4.18%.