The front part of the US yield curve is not done

The front part of the US yield curve is not done

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  Powell succeeded in calming and unnerved bond market. However, yesterday's 2-year US Treasury auction was disappointing following the 5bps hike in IOER/RRP rate. It leads us to believe that today and tomorrow 5-, and 7-year auctions might be vulnerable to investors' demand ahead of the personal consumption data. The divergence between the bond market and eurodollar futures reveals that yields in the front part of the yield curve are poised to rise much higher.


The market has all the reasons to take the Federal Reserve with a pinch of salt. Powell announced that the central bank would start talking about tapering, despite rejecting the idea entirely until last week. Additionally, he hiked the IOER/RRP rate by 5bps in a move branded as "technical" at the same meeting.

The actions of the Fed speak more than a thousand words. Although the Fed is in complete denial, it did hike interest rates last week. The abrupt bear-flattening of the yield curve indicated that the move was not priced in by investors as they stuck to the Fed’s dovish communications. It seems that the market is committing the same mistake all over again. Following the speeches of Mester, Williams and Powell's testimony to Congress, investors are ready to believe in whatever the Fed says to them blindly.

What could have been a nasty 2-year auction turned out to be just disappointing, with the yield tailing 0.05bps, the biggest since July 2020. Foreign investors demand dropped considerably from last month’s 57.1% to 50.6%. Yet, weak bidding metrics failed to move the market in a sign that the bond market buys into the Fed's message despite last week's massive reversal. We see a divergence in expectations between the bond market and eurodollar futures. The latter suggests a rate hike by the end of 2022, while the bond market discounts only a 2023 rate hike. A yield of 0.50%, double to what 2-year notes are offering now, would better indicate future rate hike expectations. However, it doesn't seem bond investors will move forwards until Federal Reserve becomes more hawkish.

The picture that the bond market is providing is quite pessimistic because it might reflect the expectations that the measures taken by the Federal Reserve to hike the IOER/RRP rate and to unwind its corporate bond portfolio gradually might be too much for the market to tolerate. Yet, the central bank raised growth and inflation forecasts signalling that more tightening might be needed. Thus, although things can change quickly after summer, we might still be facing a calm summer ahead with 10-year yields trading rangebound amid lower liquidity.

Don’t get too comfortable yet: this week's personal consumption data may still shake up things. The PCE Index is the favourite inflation indicator of the federal reserve. It is expected to rise to 3.4% from 3.1% YoY in May, which would be the highest reading since 1991. The belly of the curve will be most vulnerable to any surprise, and today and tomorrow's 5- and 7-year US Treasury auctions might provide insight into how investors are positioning ahead of this data.

The belly of the curve has suffered from weak demand for almost a year now. During the latest 5-year US Treasury auction in May, we saw the bid-to-cover ratio rising above the five year average for the first time since August, signalling improved demand for these securities. Yet, the higher demand might have been caused by leakage of liquidity from money markets. Today it will be crucial to see if demand deteriorates following the 5bps rate hike in IOER/RRP. Suppose the bid-to-cover ratio were to fall again below the 5-year average. In that case, it might mean that the rate hikes in the money market are drying liquidity up on the front part of the yield curve, making it more vulnerable to inflation surprises. Thus, tomorrow's 7-year auction could be more volatile and moving markets substantially. Although we have seen demand for 7-year notes improving since their dreadful auction back in February, the bid-to-cover remains well below the five-year average
Source: Bloomberg and Saxo Group.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank (Schweiz) AG
Beethovenstrasse 33
CH-8002
Zurich
Switzerland

Contact Saxo

Select region

Switzerland
Switzerland

All trading carries risk. Losses can exceed deposits on margin products. You should consider whether you understand how our products work and whether you can afford to take the high risk of losing your money. To help you understand the risks involved we have put together a general Risk Warning series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. The KIDs can be accessed within the trading platform. Please note that the full prospectus can be obtained free of charge from Saxo Bank (Switzerland) ltd. or the issuer.

This website can be accessed worldwide however the information on the website is related to Saxo Bank (Switzerland) Ltd. All clients will directly engage with Saxo Bank (Switzerland) Ltd. and all client agreements will be entered into with Saxo Bank (Switzerland) Ltd. and thus governed by Swiss Law.

The content of this website represents marketing material and has not been notified or submitted to any supervisory authority.

If you contact Saxo Bank (Switzerland) Ltd. or visit this website, you acknowledge and agree that any data that you transmit to Saxo Bank (Switzerland) Ltd., either through this website, by telephone or by any other means of communication (e.g. e-mail), may be collected or recorded and transferred to other Saxo Bank Group companies or third parties in Switzerland or abroad and may be stored or otherwise processed by them or Saxo Bank (Switzerland) Ltd. You release Saxo Bank (Switzerland) Ltd. from its obligations under Swiss banking and securities dealer secrecies and, to the extent permitted by law, data protection laws as well as other laws and obligations to protect privacy. Saxo Bank (Switzerland) Ltd. has implemented appropriate technical and organizational measures to protect data from unauthorized processing and disclosure and applies appropriate safeguards to guarantee adequate protection of such data.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc.