Senior Fixed Income Strategist
Summary: Following last week's dreadful 30-year U.S. Treasury auction and the University of Michigan's 5- to 10-year inflation expectations rising to the highest since 2011, the bear-steepening trend of the U.S. yield curve remains intact. As medium-term inflation trends stay anchored and the economy is buoyant, there is no chance for the Federal Reserve to turn dovish even if today's CPI numbers show a sensible deceleration of price pressures. As the Fed remains higher for longer, the yield curve will bear-steepen, and long-term U.S. Treasury yields will likely continue to rise through the end of the year. Despite a bond rally that saw 10-year yields dropping from 5% to just below 4.5%, yields remain in an uptrend, and we expect them to rise towards 4.8% in the short term and to test 5% again by the end of the year. Within this environment, we favor a bond barbell strategy involving the front part of the yield curve, up to three years, and the 10-year tenor. Moody’s rating outlook change is consistent with higher yields; however, if a downgrade materializes, it can provoke a rally in U.S. Treasuries as markets need to reconsider credit risk.
The rally in U.S. Treasuries following the FOMC rate decision of the first of November proved short-lived. Last week’s 3-, 10- and 30-year note auctions revealed bond investors' positioning amid an uncertain macroeconomic environment and monetary policies, and the message was clear: duration is still not appealing.
Last week started with a solid 3-year auction, stopping through by 0.1 basis points for the first time after two tailing auctions of the same tenor. The spike of indirect bidders from 56% the previous month to 64.6% mirrors markets’ expectations that the Federal Reserve is done with the hiking cycle. The three-year U.S. Treasury notes are paying 4.83% in yield. For investors to start losing money, yields must increase by more than 100bps, requiring the Federal Reserve to hike multiple times in the foreseeable future. As the economy decelerates, such an outcome becomes more and more unattainable.
Demand wasn’t as remarkable at the 10-year U.S. Treasury auction on Wednesday. Despite a considerable spike in indirect bidders from 60.3% to 69.7%, the bid-to-cover dropped to 2.45x, the lowest since June. The auction tailed When Issued by 0.8 basis points, showing cracks in demand for duration.
The situation dramatically changed on Thursday when an ugly 30-year U.S. Treasury auction saw a tail of 5.3 basis points, the biggest on record (since 2016). Dealers were forced to buy 24.7% of the issuance, double the recent average and the highest since November 2021. A deep selloff followed and was concentrated in long-term Treasuries, reigniting the bear-steepening of the yield curve.
That was enough to reignite a bear steepening of the yield curve. As Kim Cramer Larsson explains here, despite 10-year Treasury yields indicated a reversal of uptrend last week after closing below 4.50%, the RSI didn’t close below 40 threshold i.e., not confirming a downtrend. At the same time, the future has now resumed downtrend. Yields could move to 4.80%.
On Friday, the University of Michigan's 5- to 10-year inflation expectations rose to 3.2%, the highest since the 2011 Arab Spring. Despite being merely a survey, it is considered one of the most important inflation expectation measures and market moving. It shows that despite the Federal Reserve has hiked rates aggressively, inflation expectations remain well anchored, and they might continue to feed through price pressures. If people expect prices to rise by 3.2%, businesses will look to raise prices by this amount, and workers will seek a comparable salary increase.
It's also key to recognize that the University of Michigan inflation expectations are not the only metrics showing that inflation might be sticky on the long run. The 5-year-5-year forward inflation swap forward rate has risen significantly since the beginning of the year, and it remains well above the 2% target.
As medium-term inflation expectations remain sticky, is unlikely that the Federal Reserve will change narrative, hence we can expect it to stick to the higher-for-longer narrative. If markets believe that a pivot is nearby, investors will position for interest rate cuts, causing a drop in yields across the yield curve and easing financial conditions. As long as inflation remains well above target and real growth well above 0%, it is unlikely that the central bank will want to ease the economy.
Today’s US CPI numbers will be a focus for bond markets. The headline CPI figures are expected to drop from 3.7% in September to 3.3% in October. However, the core CPI data are expected to remain at 4.1%, flat from September, showing a 0.3% MoM increase. That should be enough to keep markets on edge, exposing the long part of the yield curve to further selloff.
As a cherry on top of the cake, on Friday, Moody’s changed the outlook on the long-term rating of the United States from stable to negative. Moody's is the only rating agency leaving the country with Aaa, while S&P and Fitch have already downgraded it to AA+. The news didn't generate market volatility because investors had enough time to consider what a downgrade might mean for their portfolios this summer when Fitch downgraded the country to AA+ in August, making the U.S. a split-rated AA+ country. We have discovered that it doesn't matter if the country is rated AAA or AA+. Regardless of the rating, financial contracts refer to “AAA or debt backed by the U.S. Government”; hence, a downgrade wouldn’t provoke a forced unwind of repurchase agreements, loans, and derivatives.
Counterintuitively, a third and last downgrade to AA+ might provoke a rally in U.S. Treasuries. Indeed, if the United States is rated AA+, companies operating in the U.S. will need to be respectively re-rated. How can companies such as Microsoft and Johnson and Johnson have a better rating than U.S. Treasuries? Would these companies be more likely to repay their debt in a credit event than the U.S. Treasury?
Changes in corporate ratings might provoke volatility in credit markets, favoring U.S. Treasuries in the near term.
The yield curve will continue to steepen. The bear-steepening of the yield curve will likely continue until the year's end as the economy remains buoyant and the Federal Reserve stays on hold. A switch to a bull-steepen is likely next year as the U.S. Economy decelerates markedly and inflation expectations continue to drop.
Within this environment, a bond barbell strategy involving the front part of the yield curve up to 3-year and the ten-year tenor might prove advantageous. In the front part of the yield curve, it is almost impossible to lose money. Two-year U.S. Treasury pays 5% in yield, and this position will be in red only if yields rise by 200 basis points or more. Ten-year US Treasuries also offer an attractive risk-reward rating. Considering a one-year holding period, 10-year notes will provide a total return of -2.25% if yields rise by 100bps, but they will pay +12% if yields drop by 100bps, protecting in case of a recession or a credit tail event.
We remain defensive regarding duration and continue to dislike the ultra-long part of the yield curve. Another test will come next week when the Treasury sells 20-year notes.
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