The “huge rebound” that has just begun in the US Treasury bond market is facing the next major “test of sanity”: a critical US bond auction event will help measure whether investors in US debt rationally believe that the “US debt sell-off wave” for most of 2023 has come to an end.

Spurred by slowing inflation and signs of a cooling US economy, traders and institutional investors have recently bought US Treasury bonds, while retail investors have made a big splash in buying various ETF products related to US bonds. Signs of a slowdown in US economic growth have significantly boosted market demand for bonds of various matrices. At the same time, they believe that with inflation data and the labor market cooling down sharply, the Fed has ended the most aggressive cycle of interest rate hikes in a generation, and they expect the Fed to shift to a cycle of interest rate cuts in the middle of next year, thus continuing to push US bond yields downward.

Driven by this strong purchasing power, the price of US Treasury bonds ended a six-month continuous downward trend and pushed the overall US debt market to rise 2.6% in November. This figure is the biggest increase since March. At the time, people feared that the US regional banking crisis caused by the bankruptcy of Silicon Valley banks would drag down the US economy, so they bought US bonds one after another to seek reliable safe haven routes.

However, the feverish rise in US bond prices this month has pushed 10-year US Treasury yields to their lowest level since September. Meanwhile, demand for the 20-year US Treasury bond auction on Monday local time may become the most important indicator of whether traders and institutional investors think that the recent trend is at risk of reversal. This concern was particularly evident in the 30-year US bond auction earlier this month. At that time, the US Treasury had to sell these bonds at an unusually high yield premium on US bonds, causing a brief decline in the US bond market.

The US Treasury's 20-year treasury bond issuance volume has been a heavy burden of treasury bond issuance for most of the three-year issuance period. During this period, it was never sold during the US Thanksgiving holiday. Therefore, strong demand acceptance will be the strongest support for this huge rebound in US debt prices.

William Marshall (William Marshall), head of US interest rate strategy at BNP Paribas (BNP Paribas), said, “This important US debt auction process can be described as a “test of sanity” for investors, and will be a good test of the market's view that the overall evolution brought about by economic data has moved the market to a more stability/more constructive purchasing process in a meaningful way to determine how long-term US debt supply is absorbed.”

This time, is the “anchor of global asset pricing” really stuck or is it dancing again?

Over the past year, particularly in September-October, it can be said that bond traders' confidence has been under constant shock, as economic data such as an unexpectedly strong economy and stubborn inflation rates have suppressed several sharp rebounds triggered by speculation that the Fed will stop raising interest rates. The ever-expanding federal deficit has also played an important role in stimulating the rise in US bond yields. The high size of the US federal government deficit is testing the market's ability to fully absorb all the new debt it finances.

Spurred by strong economic data and the rising US federal deficit, the yield on 10-year US Treasury bonds, which has the title of “anchor of global asset pricing,” surged sharply above 5% in October, hitting a new high since 2007 in one fell swoop. The sharp trend in US bond yields has caused US debt bulls' investment portfolios to suffer heavy losses (US bond price changes and yield changes show a reverse trend), but traders are still looking for a glimmer of hope in the worst US bond bear market in decades — that is, higher fixed yields provide greater protection for investment portfolios, and US bond buying is expected to become stronger under the US economic slowdown.

From a theoretical point of view, the 10-year US Treasury yield is equivalent to the R index at the denominator end of the DCF valuation model, an important valuation model in the stock market. Wall Street analysts generally set r values based on 10-year US bond yields. When there are no significant changes in other indicators (especially cash flow expectations) or even a decline in expectations, the higher the denominator level or continues to operate at a higher level, the valuations of risky assets such as high-valued technology stocks, high-risk corporate bonds, and riskier emerging market currencies face a collapse.

However, there are signs this month that the US labor market is cooling down and inflation is being brought under control, which reinforces the market's belief that the Fed's monetary policy is sufficiently restrictive and that the interest rate hike cycle is over. At the same time, the increase in the scale of US debt auctions announced by the Ministry of Finance was less than the general expectations of bond traders, especially the auction scale of long-term US bonds, which allayed concerns about the supply of US bonds in some markets.

Despite this, the 30-year US Treasury bond auction on November 9 still yielded far higher than expected treasury bond yields. This sign of weak demand triggered a wave of phased sell-off in the US bond market that day. However, facts prove that this downturn in prices is short-lived. Investors have profited from high yields, and bond prices have continued to rise. At the same time, the US bond yield fell from a starting level of about 4.77% to a phased low of 4.56% on Friday.

Although demand for 20-year US bonds continues to weaken, making their yields higher than 30-year US bonds, Marshall, head of interest rate strategy from BNP Paribas, said that since the US Treasury reduced the scale of issuance of 10-year and 30-year treasury bonds compared to 10-year and 30-year treasury bonds, the overall performance of 20-year treasury bonds in auction activities has improved. Monday's auction was set at $16 billion, while this month's 30-year treasury bond auction was $24 billion.

Even so, 20-year US Treasury bonds have failed to keep up with the recent rise in the US Treasury bond market. This shows that the market is aware that the continued scale of US debt auctions may lead to oversupply, making it more difficult to auction US bonds. Therefore, if there is an oversupply situation in the US bond auction event, compounded by the fact that the size of the federal deficit continues to ferment, the 10-year US Treasury yield, which has the title of “anchor of global asset pricing,” as well as the yield of US bonds of various terms, may return to the “big trend” on the curve.

Various data are quietly driving the buying of US bonds. Is the market overly concerned about US bond auctions?

“People understand that there may be a volume and liquidity vacuum in auction activities, but investors are still imagining that the market is trying to make room for US debt auctions.” William O'Donnell, an interest rate strategist at Citigroup Inc. (Citigroup Inc.), said when talking about the auction.

“I don't think supply will be a serious concern for the market right now.” “Sometimes, we even feel there's not enough supply.” “This was the case on Tuesday. Amidst gains driven by October consumer price index (CPI) data, demand for 5-year US Treasury yields was strong, and yields fell by as much as 25 basis points.

“Given Bloomberg Economics's general opinion, US Treasury bonds are expected to return up to a double-digit ratio in 2024. This year's demand will begin with concerns about a recession and be followed by a moderate recovery. As the market expects monetary policy to be more relaxed and inflation to fall, demand for US Treasury bonds is likely to exceed supply, but the federal deficit will continue to be a cause of concern — this is a major factor disrupting US debt. Bloomberg Economics interest rate strategists Ira Jersey and Will Hoffman said.

Key US economic indicators to be announced this week include durable goods orders for October. From a global perspective, the purchasing managers' index (PMI index) for the UK and Eurozone will soon be released.

What is certain is that concerns remain. The downward trend in US bond yields this week is partly due to the sharp slowdown in US CPI and PPI, and the recent collapse in international oil prices. However, as oil prices rebounded from their lowest level since July, the US bond rally lost momentum for a while on Friday.

Furthermore, traders may have predicted in advance that the Federal Reserve will switch to cutting interest rates by June and cut interest rates a total of four times by December 2024. Expectations of interest rate cuts are also an important factor driving the US bond price upward in the near future. However, Fed officials previously predicted in the September bitmap that according to their median estimate, interest rates would not be cut more than once next year.

After the announcement of the US CPI and PPI, which have cooled beyond expectations, and the number of US unemployment claims that have continued to rise for many weeks, the CME “Fed Watch Tool” showed that interest rate futures traders are betting that the Fed's interest rate hike cycle is over. Expectations for the Fed's interest rate cut cycle to begin in May next year are rapidly heating up, betting that the Fed will cut interest rates by nearly 100 basis points from May.

In addition to the above factors, there is also a very important point that can be seen from the scale of ETF capital inflows related to US bonds with a 20-year term and above. They also make portfolios more resilient during periods of continued pain in risky asset markets.

Roger Hallam, head of global interest rates at Vanguard Asset Management (Vanguard Asset Management), said that the asset management giant has been buying US Treasury bonds with a term of 5 to 10 years recently and plans to increase the scale of purchases if the yield curve rises further.

In October, Michael Hartnett, chief investment strategist at Bank of America, shouted that US bonds will be the best performing asset in the first half of 2024. The strategist emphasized, “The current yield level creates an opportunity for US bonds to bring equity-like returns. Due to the prominence of bonds, if the yield falls by 100 basis points, it will cause the return on the benchmark bond portfolio to reach 13%, while an increase of 100 basis points will only lead to a -0.2% decline.”

However, Leslie Falconio (Leslie Falconio), head of taxable fixed income strategy from UBS's global wealth management department, said: “However, the risk in the bond market is that as market expectations of easing policies gradually digest, yields will gradually rise, as we have seen before, especially if the Fed's remarks at the December meeting and the latest bitmap are more hawkish.”

edit/new