Head of Fixed Income Strategy
Summary: The message is clear: in light of high inflation, increased Treasury supply, and a tight labor market, duration is not appealing. An escalation of the Israel-Hamas conflict might even reignite inflationary pressures. That’s why yield curves resumed their bear-steepening trend on both sides of the Atlantic, and ultra-long maturities remain at risk. This week, the attention turns to the 20-year US Treasury auction and Powell's speech on Thursday. We favor the front part of the yield curve, particularly 2-year tenors, which offer a win-win solution amid the current uncertain macroeconomic backdrop. The 10-year benchmarks also bring a good risk-reward ratio; however, we expect the 10-year US Treasury yield to continue to soar and break above 5%.
The week started with a considerable sell-off in rates on both sides of the Atlantic. Ten- and thirty-year US Treasuries yields rose by 15bps since Friday's close to 4.75% and 4.90%, respectively. Yields returned to levels seen at the beginning of the month before the war began in the Middle East.
Safe-haven demand did little to abate bearish sentiment in long-term rates. Indeed, while war escalated between Israel and Hamas, bond investors nervously monitored US CPI numbers and US Treasury auctions. Markets are now conscious that US headline inflation remains uncomfortably high at 3.7% YoY and that war in the Middle East brings further upside risk for inflation. With the labor market remaining tight, the bond market cannot call the end of the Fed's interest rate cycle with certainty. That is why forward inflation swaps haven't moved lower; actually, they have started to soar again, with the 5-year 5-year Forward CPI swap going from 2.53% in May to 2.77% today and the USD zero coupon inflation swap going from 2.45% in May to 2.64%.
Additionally, a trillion-dollar deficit is forcing the Treasury to increase auction sizes, even on coupon issuances. Right now, the auction size for coupon issuance is comparable to the one during the 2020 Covid pandemic, with the only difference that back then, Quantitative Easing was supporting bond valuations; now, the Federal Reserve is not buying bonds any longer. Therefore, despite geopolitical tensions escalating in the Middle East, it is unsurprising to see auctions' bidding metrics deteriorating, even for the 10-year tenor.
Last week's 10-year US Treasury auction tailed by 1.8bps, the biggest tail since April, and primary dealers were left with 20.9% of the issuance, the highest since October 2022. It's fair to note that primary dealers are obliged to buy whatever isn't sold to direct and indirect bidders, and they will sell these unwanted securities following the auction. Demand at the 30-year US Treasury auction was even more dire, tailing 3.7bps, the third biggest tail on record, and the highest since November 2021. That's despite the bonds offering 4.837%, the highest auction yield for that tenor since 2007.
Last week's evidence is clear: nobody wants to increase their portfolio's duration as the Treasury sells large amounts of Treasuries, and inflation remains elevated. That concept is likely to be emphasized again this week at the 20-year US Treasury auction, a tenor typically disliked by markets.
Therefore, long-term yields should continue to rise, with the 10-year yields breaking above 5% and possibly rising to 5.25%. Consequently, we remain defensive and favor the short-term maturities, as the yield curve is poised to continue to bear-steepen. Still, front-term yields remain anchored as the Federal Reserve is supposed to have reached the peak of the hiking cycle, but it will stay on hold for longer.
In the UK, wages and inflation are slowing but remain uncomfortably high. While we may be close to the end of the Bank of England's tightening cycle, we are definitively not facing the economic conditions for the central bank to begin easing financial conditions. Therefore, we might face a similar problem to the US, where the higher-for-longer theme will continue to push long-term yields.
Not only that, but Gilts remain correlated to US Treasuries, which yields, as we have explained above, remain on the rise. If you would like to learn more about why we expect Gilt yields to continue to rise, please refer to this link.
We, therefore, continue to favor the front part of the yield curve and quality in the UK.
We favor the front part of the yield curve because the macroeconomic backdrop remains relatively uncertain. An escalation of the war between Israel and Hamas and a possible involvement of the US in the area might mean more spending, hence more bond issuance on top of the already increasing bond supply due to a large ongoing fiscal deficit. That would continue to pressure US Treasuries unless the Federal Reserve steps back from its tightening stance.
At the same time, war increases the chance for inflation to rebound. Hence, the tail event, which sees inflation rebounding in the next few months, might become a reality. In that case, central banks might need to hike rates a few more times. Short-term bonds will prove resilient within that tail scenario, while duration will pose the most significant risks to investors' portfolios.
Yet, it's impossible not to look at the safe havens with interest. If this is the last stretch higher for rates, they might already provide an interesting risk-reward scenario. Indeed, if yields rise another 50bps, German Bunds, US Treasuries, and Gilts would still be in the green. That's different for ultra-long maturities, where the direction of monetary policies needs to become more benevolent for these positions to perform.
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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.
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