Head of Fixed Income Strategy
Summary: Technical analysis shows that there is space for the US yield curve to flatten amid the US election. However, in the long-term, only a steepening is possible with the 30-year Treasury yields leading the way. The Fed will need to decide soon whether expanding its bond purchasing programme over long-term maturities to avoid a fast steepening of the yield curve.
Even though yesterday the market was a red sea with US equity indices falling around 3.5%, the bond market saw US Treasury yields barely moving. The front end of the yield curve 2s10s was stable while the 5s30s steepened slightly by one basis point. The US Treasury yesterday was able to sell $55bn of 5-year government bonds at a yield of 0.33%, which was 0.5% below the market's expectations. Investors' participation in the auction is key to understanding the prevailing sentiment in the bond market. The bid-to-cover ratio was below the 1-year average, and more than 60% of the notes were awarded to indirect bidders. This means that while foreign demand continues to drive US Treasuries performance, domestic government bond demand is slowing down amid the US election and the reflation story.
To understand how US Treasuries will perform going into the US election week, we can analyze the part of the yield curve that is currently being most active: the 5s30s.
This year, the long part of the yield curve is steepening faster compared to what we have seen from the second half of 2018 until the beginning of this year. The 5s30s spread is trading in an ascending wedge which has tested already twice. It would not be surprising to see the spread trying the support line as we get closer to the election. If the support line is broken, we can see the spread finding the first level of support at 109.30.
At present, long term yields are the biggest movers of the US yield curve. Thus, movements in 30-year yields are critical to understanding the yield curve direction.
Below you find a candle chart of the 30-year Treasury yield since the beginning of the year until today. As you can see, the 30-year yield broke above what it used to be its resistance line. The new support line has already been tested twice. As the election approaches and we experience more volatility in the equity market, it will most likely be tested again. If risk-off sentiment pushes yields below the support line, the 30-year yields will find support at 1.42%.
Even though we can see a slight flattening of the yield curve in the short term, in the long-term, some elements point to the fact that only a steepening of the yield curve is possible.
As the graph below shows, sentiment over US Treasuries has deteriorated since the beginning of the year until today. However, Treasury yields didn't rise because of recent risk-off trading dynamics. We expect this to change as reflation becomes a more threatening factor after the US election, especially if Biden wins.
Investors are increasing their short positions in US Treasury futures as reflation becomes a real threat. 30-year Treasuries are falling faster compared to 10-year Treasuries because the Federal Reserve accommodative monetary policies control the front part of the yield curve. Suppose the Fed doesn't want Treasury yields to rising fast after the elections. In that case, it may need to expand its bond purchasing programme to longer-term maturities.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
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.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
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