Head of Fixed Income Strategy
Summary: Yesterday's solid 20-year US Treasury auction shows that real money continues to bet on weaker global growth and inflation expectations, which can come together with a significant risk-off event. However, we expect long-term yields to rise as the Federal Reserve begins its interest rate hiking cycle. Even if the central bank returns to its accommodative stance shortly after, there is the chance that inflation will remain a problem, requiring aggressive monetary policies in the future. Therefore, we see considerable downside potential for long-term Treasuries.
Yesterday’s 20-year auction was the last long-term bond sale of the year. It had all the elements to ignite a selloff in the long part of the yield curve, but it didn't. It rescued long-term bonds in a day of intense bear-steepening.
Before the bond sale, the US yield curve followed the steepening trend of its European counterparts. Long-term yields rose rapidly as interest rate hiking expectations advanced in the UK, with the OIS curve currently pricing a 21bps rate hike already by February. A second rate hike in the UK will allow the BOE to begin winding down its balance sheet. Such a move implies higher yields across the whole yield curve. Hence, the steepening.
Twenty-year US Treasury yields rose by 7bps ahead of the auction. Everything pointed to a weak bond sale as this tenor usually is not loved, and the market is illiquid amid Christmas. However, stronger than expected investors’ demand reverted losses in the long part of the yield curve. The bid-to-cover rose to 2.59x, the highest since June 2020, while primary dealers were left with a record low of 14.3%. The auction stopped through the WI by 2.3bps pricing with a high yield of 1.942%.
It is another confirmation that the market is betting on weaker global growth and inflation expectations, which might have a significant risk-off event in the stock market. Within this scenario, long-term bonds serve as a “crash insurance" on the economy, and real money is not afraid to increase its position in this part of the curve.
Yet, the long part of the yield curve rally might not last beyond the first quarter of 2022. As the Federal Reserve finishes taper purchases under its QE program, the beginning of a tightening cycle will become nearer, and a rise in yields across the whole curve will be unavoidable. As the chart below shows, 10-year yields have always shifted higher during previous interest rate hiking cycles. It’s prudent to assume that the same thing will happen this time around.
There is another thing to consider: inflation remains an underestimated threat. If the central bank returns to its accommodative stance due to a market selloff soon after it embarks on a tightening journey, there is the chance that inflation might rise even further. In that case, the Fed won’t have any other alternative rather than continuing hiking interest rates.
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As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
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