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

Summary:

• Strong Foreign Demand Likely to Support Auction: The upcoming 5- and 7-year U.S. Treasury auctions are expected to attract strong demand, particularly from European investors, as these notes offer a yield premium over German sovereigns when hedged against the euro. While U.S. Treasuries remain unattractive for Japanese investors due to deeply negative yields once hedged against the yen, increased demand from European investors is likely to offset concerns about the large issuance volumes.
• Watch for Signs of Market Sentiment Shift: The outcome of these auctions will provide a critical gauge of market sentiment regarding economic conditions and inflation expectations. A strong 5- and 7-year auction would suggest growing confidence that inflation is under control and rate cuts are imminent. Conversely, weaker demand, particularly if paired with stronger inflation data, could signal rising concerns about inflation amid aggressive interest rate cuts.
• A stronger U.S. dollar driven by increased foreign demand, rising gold prices as investors seek inflation hedges, and heightened volatility in equities could be some of the key consequences from this week's U.S. Treasury auctions.

Key Market Implications of This Week's U.S. Treasury Auctions

1. Bond Market Implications: Yield Curve Normalization. The market expects the yield curve to normalize as long-term yields rise, which could impact bond pricing. A steeper yield curve may drive demand towards short- and medium-term bonds as investors seek higher relative returns with lower duration risk.

2. FX Implications: Strong Dollar. U.S. Treasuries are becoming more attractive to European investors, particularly due to a favorable yield differential when hedged for EUR. This could lead to increased foreign participation in Treasury auctions, potentially supporting the U.S. dollar as European demand rises. Conversely, JPY-hedged U.S. Treasuries remain less appealing compared to Japanese government bonds, which may temper demand from Japan.

3. Equity Market Implications: Equity Volatility. Increasing volatility in bond markets, particularly if PCE data comes in hotter than expected, could spill over into equities. Higher bond yields and rate uncertainty may weigh on equity valuations, especially in growth sectors sensitive to interest rate changes, like technology.

4. Commodities Implications: rise in gold. Strong demand for mid- and long-term U.S. Treasuries, coupled with concerns about inflation data, could signal mixed investor sentiment toward inflation-sensitive assets such as commodities. A hotter PCE report may push investors to seek inflation hedges like gold and commodities, increasing demand in those markets.

Anticipated Market Dynamics: U.S. Treasuries More Appealing for European Investors, Supporting Strong Auction Demand.

The upcoming U.S. Treasury auctions are well-positioned for strong demand due to several key factors:

• Attractive Yields: Although yields are lower compared to the last couple of years, they still remain well above the average yields observed between the global financial crisis and the onset of COVID-19. This makes Treasuries relatively attractive even in a lower yield environment.
• Increased Appeal to European Investors: U.S. Treasuries, especially the 2-, 5-, and 7-year maturities, are offering a more favorable yield pickup for EUR-hedged European investors compared to German sovereign bonds of the same tenor. A month ago, these Treasuries offered lower yields on a hedged basis, but the recent shift could drive higher foreign demand. In contrast, JPY-hedged US Treasuries remain less attractive compared to Japanese Government bonds.
• Stable Auction Size: Despite large issuance volumes comparable to those seen during the COVID pandemic, auction sizes remain unchanged, potentially alleviating supply concerns.
• Focus on the 5-Year Treasury Auction: While the bid-to-cover (BTC) ratio for 5-year U.S. Treasuries has been gradually declining since January 2023, the improved appeal for foreign investors, as noted above, could result in a BTC rebound. Keep an eye on this auction for potential signs of a tail.

These factors suggest strong support for this week's Treasury auctions, especially as foreign investors may increase their participation.

Key 5- and 7-Year Treasury Auctions: A Gauge of Economic Confidence and Inflation Expectations

The upcoming 5- and 7-year U.S. Treasury auctions will serve as important indicators of market appetite for mid- to longer-term debt, especially in the context of rising economic uncertainty. Since last week's FOMC meeting, the 10-year Treasury yield has increased from around 3.6% to 3.75%, driven by growing belief in the possibility of a soft landing. However, that optimism has been shaken by yesterday's sharp drop in consumer confidence, where the present situation indicator fell by 10 points to 124, the largest decline since August 2021, signaling increasing concerns over labor market conditions.

The auctions take place just ahead of the Personal Consumption Expenditures (PCE) report, the Federal Reserve’s preferred inflation gauge. The market expects core PCE to rise slightly to 2.7% from July’s 2.6%. Strong demand in these Treasury auctions could indicate growing concern about the economic outlook and confidence that inflation remains under control. However, if the auctions rally before a hotter-than-expected PCE report, rates volatility may further increase, potentially leading to higher long-term yields and further normalization of the yield curve.

Strong Demand in Latest 2-Year U.S. Treasury Auction Amid Rising Expectations of Aggressive Fed Rate Cuts.

Yesterday’s $69 billion auction of 2-year U.S. Treasury notes priced on the screws with a High Yield of 3.520%, the lowest for this maturity since August 2022. The front end of the yield curve remains well-supported, as markets anticipate significant rate cuts from the Federal Reserve in the upcoming meetings.

Swap contracts currently reflect expectations for both a 50 and 25 basis point cut by year-end, with a 50% chance of a cut happening in November. Currently, markets are pricing in a total of 78 basis points in rate cuts by the end of the year, while the Federal Reserve’s latest dot plot suggests a more moderate 50 basis point reduction. This divergence highlights the ongoing uncertainty between market expectations and the Fed's projected path, which could increase volatility going forward.

The bid-to-cover (BTC) ratio for the 2-year auction came in at 2.59, down from 2.81 in July but in line with historical averages from 2021 and 2022. As a reference, the BTC ratio for 2-year auctions hit a record high in January 2023 as investor preferred the short part of the yield curve over longer Treasuries carrying higher duration.

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