Insights into this week's US Treasury auctions: 2-, 5-, and 7-year overview.

Summary:

• U.S. Treasury auctions at risk amid rich valuation, heavy supply and economic resilience. This week’s U.S. Treasury auctions are exposed to a tail due to a disconnect between the macroeconomic backdrop and market expectations for aggressive rate cuts by the Federal Reserve, and large issuance sizes. While bond futures are pricing in significant rate cuts, economic indicators like steady jobless claims and solid GDP growth suggest that the economy is more resilient than markets anticipate. If the economic data continues to defy expectations, weak bidding metrics at the auctions could signal a rejection of current market pricing, leading to a potential bear flattening of the yield curve.
• The 5-year U.S. Treasury auction might be most exposed to a tail. Its issue size remains at a record high of $70 billion, making it more difficult for markets to absorb. Additionally, the recent sharp decline in yields has diminished its appeal, particularly to foreign investors, as it offers lower JPY- and EUR-hedged yields compared to the 2- and 7-year notes, and falls well below yields offered by EUR and JPY counterparts.
• Recent auctions reveal investors' continued caution on extending duration. While demand for shorter-term 2-year notes has grown steadily since early 2023, the flat demand for 5- and 7-year tenors, coupled with an increased reliance on primary dealers, indicates a hesitation to commit to longer durations. This reluctance is likely driven by uncertainty surrounding future rate cuts and broader economic conditions.

Anticipated Market Dynamics

Since early June, U.S. Treasury yields for 2-, 5-, and 7-year maturities have fallen sharply by around 100 basis points, reaching 3.89%, 3.63%, and 3.68%, respectively—their lowest levels since spring/summer 2023. This rapid decline in yields raises the question of whether investors will see value in extending their portfolio duration, especially with the bond market now pricing in an aggressive rate-cutting cycle, which the Federal Reserve might not be able to deliver.

The U.S. Treasury auctions in August provide some insight into investor sentiment. The 10- and 30-year auctions saw an increase in awards to primary dealers, which could be attributed to reduced liquidity during the summer lull or reluctance to extend bond duration given the rich valuations following the unwinding of the yen carry trade earlier in the month. However, last week’s 20-year auction was relatively well-received, with a noticeable drop in indirect bidder participation offset by a rise in direct bidder demand. These mixed results suggests that investors are still cautious about significantly increasing duration in their portfolios, despite anticipations for a significant slowdown of the U.S. economy.

As we look ahead to this week’s auctions, it’s important to consider that markets are preparing for a busy start to September—a month historically marked by heavy corporate bond issuance. Consequently, investors might be hesitant to significantly extend duration just ahead of it. With the Treasury set to sell $211 billion in coupon notes (including $28 billion of a 2-year floater, which is not discussed here), any weakness in demand could lead to auction tails and increased volatility in secondary markets.

Since the beginning of 2023, demand from both indirect and direct bidders for the 2-year tenor has steadily increased. In January 2023, indirect bidders accounted for 65% of the 2-year U.S. Treasury auction, rising to 75% by the latest auction on July 23rd. Direct bidder participation, however, has seen more fluctuation—rising from 18.7% in January last year to 25.5% in May 2024, before dropping to 14.4% in July, the lowest level since February 2022. In contrast, demand for the 5- and 7-year tenors has remained relatively flat during the same period, with primary dealer (PD) awards gradually increasing.

A rising primary dealer award typically signals weaker demand from other investors, requiring primary dealers to take on a larger share of the issuance. While the current PD awards are not yet at alarming levels, as they remain below the highs seen during the COVID-19 pandemic, they do reflect ongoing challenges in the U.S. Treasury market, particularly in light of the growing national debt. Notably, ahead of this week’s auctions, while PD awards for 2- and 7-year notes have significantly declined since May, the awards for 5-year notes continue to trend upward, highlighting potential concerns in that segment of the market.

As a result, this week’s 5-year U.S. Treasury auction is anticipated to be the most vulnerable, with a higher likelihood of underperforming compared to the 2- and 7-year auctions. Not only the issue size remains at a record high size of $70 billion since April, the risk-reward profile of these notes may no longer be as appealing to foreign investors as it was a few months ago, which could lead to a decline in indirect demand. Among the three tenors being auctioned this week, the 5-year notes offer the lowest JPY- and EUR-hedged yields, at -1.4% and 2% respectively—significantly below the yields provided by similarly currency hedged 2- and 7-year notes. Additionally, these notes offer lower yields than their EUR and JPY counterparts of the same maturity, further diminishing their appeal to foreign investors.

On the other hand, we expect solid demand at the upcoming 2-year and 7-year auctions, despite the recent drop in yields. The risk-reward proposition of the 2-year tenor remains strong, making it an attractive option for investors looking to park cash in the mid-term. Although the 7-year tenor is less compelling in term of risk-reward, its relatively smaller auction size could generate strong support.

What implications does this hold for bond markets?

Although the 5-year U.S. Treasury auction is the most exposed to a tail, it's important to recognize that the macroeconomic backdrop contrasts with market expectations of an aggressive rate-cutting cycle by the Federal Reserve. Bond futures are currently pricing in a 2/3 probability of a 50 basis point rate cut in September and anticipate 100bps rate cuts by the end of the year. However, key economic indicators tell a different story: jobless claims remain consistent with their long-term average, and the economy continues to grow at or above trend, with the Atlanta Fed's GDPNow estimate at around 2% ahead of the second quarter GDP revision on Thursday.

While it is impossible to time markets precisely, a rejection of current market pricing could be triggered by weak bidding metrics at U.S. Treasury auctions, as real money begin to push back against the rich valuations in the U.S. Treasury market. If the economic environment remains resilient, markets may need to reassess their expectations for aggressive rate cuts. This could lead to a bear flattening of the U.S. yield curve, where short-term yields rise more rapidly than long-term yields as investors adjust to a less accommodative monetary policy outlook.

Analyzing the upsides and downsides of this week's 2-, 5-, and 7-year auctions.