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

Summary:

• This week’s two- and five-year auctions are likely to draw solid demand. Despite their record auction sizes, these tenors offer a compelling risk-reward profile amidst an evolving macroeconomic landscape.
• The elevated duration and low yield of the seven-year notes make their auction vulnerable to weak bidding metrics. While extending duration might be appealing due to increasing disinflationary pressures and a slowing economy, uncertainty regarding the U.S. election and potential economic reacceleration keeps duration buyers cautious.
• Economic data to test market appetite for duration. The auctions precede the second readings of US GDP and PCE data. The 5- and 7-year tenors are particularly sensitive to shifting market sentiment. If investors believe the Fed's fight against inflation is not over, yields in the belly of the yield curve might rise faster than other tenors. On the other hand, accelerated disinflationary pressures may lead to market expectations of rate cuts by the Federal Reserve, providing a tailwind for US Treasuries.

Anticipated Market Dynamics.

The US Treasury is set to auction $213 billion worth of coupon-bearing US Treasuries this week, spanning 2-, 5-, and 7-year tenors, along with a 2-year floating rate note auction not covered in this analysis. Despite July accounting for $122 billion in coupon redemptions and the quantitative tightening (QT) cap being reduced by $35 billion since June, the results of this month's coupon auctions have been so far mixed.

While the 30-year US Treasury auction received weak bidding metrics a couple of weeks ago, last week’s 20-year US Treasury bond sale showed good demand despite being one of the less favored tenors within the US yield curve. This favorable reception was likely due to the relatively small auction size of $13 billion, which is half the size of the auctions held during the COVID era. In contrast, the 30-year US Treasury auction was much larger, at $22 billion, which, although not at record high COVID levels, was still significantly larger than pre-COVID norms.

This week, the US Treasury continues its trend since April by auctioning record amounts of 2-, 5-, and 7-year US Treasuries. Investors might need to carefully select among these tenors, providing important insights into their comfort with adding duration to their portfolios, with a particular focus on the 5- and 7-year auctions.

We anticipate positive market reception for the 2- and 5-year US Treasury auctions, while exercising caution regarding the 7-year tenor. Although the auction size for the 2- and 5-year Treasury notes remains in line with the last three months’ record high levels, the notes’ risk-reward profile appears compelling amidst a continuously evolving macroeconomic landscape.

In contrast, the proposition presented by the 7-year notes is different, carrying the highest duration of the three and paying a low yield. Extending duration might be appealing as disinflationary pressures increase, economic activity slows down, and the Federal Reserve prepares to cut rates. However, uncertainty regarding the U.S. election or a potential reacceleration of the economy is keeping duration buyers on the sidelines.

What implications does this hold for bond markets?

The auctions come ahead of the second readings of US GDP on Thursday and PCE data on Friday. The belly of the curve (the 5- and 7-year tenors) is particularly interesting because these tenors are the first to react to shifting market sentiment. If investors believe the Fed's fight against inflation is not over, yields in the belly of the yield curve might soar faster than other tenors.

It's also important to consider the current macroeconomic context in which these auctions are occurring. The economy has been cooling, with U.S. real GDP growth decreasing from an annualized 3.4% in Q4 2023 to 1.4% in Q1 2024. However, economists expect a slight recovery in the second quarter, with an anticipated growth of 1.9% on an annualized basis.

As disinflationary pressures have recently accelerated, it’s likely that market participants expect the Federal Reserve to begin cutting rates soon, despite the slight uptick in growth. This anticipation could provide a tailwind for US Treasuries across the yield curve.

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