If inflation remains a concern, keeping hawkish will be critical for central banks across both sides of the Atlantic. At the sign of the end of the hiking cycle, the bond market will position for future rate cuts, resulting in lower yields, which might ease financing conditions and underpin inflationary pressures.
The US Treasury financing announcement is likely to trump the FOMC meeting.
On Wednesday, the US Treasury will release the quarterly refinancing announcement on the back of yesterday's disclosure of the Treasury's financing needs. This report might overshadow the FOMC meeting, as it is becoming more apparent that Treasuries are suffering from supply and demand unbalances.
During the past month, almost all the US Treasuries coupon auctions have tailed. A tail occurs when the auction prices at a higher yield than When Issued. Together with dropping indirect bidder demand, that becomes a clear sign of supply and demand asymmetry.
The issue lies in the fact that the US Treasury is trying to sell high volumes of notes compared to pre-COVID, despite traditional buyers of US government bonds having sensibly diminished. The best example is the Federal Reserve, which, through QE, has been purchasing bonds since the Global Financial Crisis until the COVID-19 pandemic. However, the Fed is now a net seller of Treasuries through Quantitative Tightening (QT). Also, foreign investors are buying less US government securities, as the cost of hedging against currency risk has increased dramatically, and they find better investment opportunities at home. Japanese investors are the largest foreign holders of US Treasuries; however, with rising JGB yields at home, it doesn't make sense for them to buy into US or European sovereigns as once hedged against the JPY they provide a negative return.
Compared to the 2010-2020 decade, coupon issuance has increased by around 60% for both 10- and 30-year securities. The Treasury went from selling an average of $22 billion in 10-year US Treasury notes every month before the pandemic to selling an average of $36 billion per month during the last quarter. The belly of the curve, therefore, Treasuries with 5- and 7-year tenors increased by roughly 30% in auction size since pre-COVID.
With a war in the Middle East escalating, and entering into an election year, spending will likely continue to increase, demanding greater borrowing from the US Treasury.
What does that mean for investors?
The US yield curve is poised to continue to bear-steepen, unless the market narrative shifts. Within this environment, we continue to favor the front part of the yield curve up to 3-year maturities and the 10-year tenor. Building a barbell will enable clients to take advantage of high yields in the front end while adding protection with 10-year US Treasuries in case a recession materializes.