This week’s US Treasury auctions will set the tone before a potential government shutdown.
The $134 billion auction of two, five, and seven-year notes may remove or apply further pressure on long-term Treasuries.
Understanding whether demand remains resilient as auction sizes have increased across longer tenors will be critical. Investors’ appetite for the 7-year notes, one of the least liked tenors together with the 20-year, will be particularly important as foreign investor demand has dropped significantly this year, with indirect bidders taking only 13.4% of the issue in 2023 compared to 16.8% in 2022. At the August 7-year auction, domestic buyers came to the rescue of disappointing foreign bidders' demand. Still, if domestic demand wanes too, it may mean that investors are positioning for a further bear-steepening of the yield curve, demanding a higher term premium. On the contrary, if the appetite for the belly of the yield curve increases, it may imply that investors are beginning to position for a bull-steepening, putting a temporary ending to the bond selloff that has taken place after last week's FOMC meeting.
A government shutdown may be beneficial for US Treasuries
Contrary to what many believe, a potential government shutdown and downgrade from Moody's may cause US Treasuries to rally rather than plunge.
A government shutdown will inevitably be a drag on economic growth and will push the unemployment rate up. The longer the shutdown, the greater the severity on the economy. A quick deterioration of the economic backdrop might create an uncertain economic environment for the Federal Reserve’s November 1st meeting, forcing the hand of policymakers to hold rates steady rather than delivering another hike. That will send a positive signal to the bond market as another pause implies that the central bank is finally done with its hiking cycle, provoking a bull steepening of the yield curve.
At the same time, considering that S&P and Fitch have already assigned an AA+ rating to the safe-haven, a downgrade from Moody's might be shrugged off by markets reasonably quickly. A downgrade from Aaa to Aa1 would reinforce the valuations of the other two rating agencies.
Long-term bonds: does it make sense to buy at current levels?
It depends on your market view and how long you want to hold these securities. If you are a long-term investor, it may make sense to increase duration exposure gradually as yields peak. The modified duration of 10-year US Treasuries (US91282CHT18) is around 8%. Yet, if these securities are held for a year, and meanwhile yields rise by 100bps, the total loss of this position would be -2.5%. If yields drop by 100bps, the total return would be 12%. Assuming that rates are about to peak, the risk-reward profile of the safe haven becomes more appealing as yields soar.
When looking at corporate bonds, we prefer quality over junk. As the highest yields in the investment grade corporate bond space are paid in the front and long part of the yield curve, investors might be interested in creating a barbell. Below is an example of well-rated short and long-term USD corporate bonds.