Analyzing market impacts: insights into the upcoming 5-year and 7-year US Treasury auctions.

Summary:

• Despite the considerable size of the auction, the 5-year US Treasury auction is poised to outperform the 7-year auction. This is due to the likelihood that the current pricing of these notes may result in the second-highest auction yield since 2007. Moreover, the 5-year notes present a more favorable risk-reward proposition compared to their 7-year counterparts.
• If the 5-year auction tails When-Issued, it's probable that the 7-year auction will also tail, potentially prompting a rise in yields across tenors prior to the release of the PCE deflator on Friday.
• Three possible outcomes loom over the upcoming US Treasury auctions. However, even in the event of robust auctions, 10-year US Treasury yields are expected to maintain their uptrend, with little chance of dropping below 4.5% as they edge closer to the 5% mark.

Why is the belly of the yield curve important?

Changes in the yields of 5-year and 7-year US Treasury notes can provide valuable insights into broader economic conditions and interest rate expectations. These tenors are often viewed as an intermediate-term horizon, capturing expectations for economic growth, inflation, and monetary policy over a reasonably foreseeable future. Consequently, shifts in the yields of these tenors can reflect changes in market sentiment and expectations for future economic performance.

The 5-year and 7-year tenors exhibit significant sensitivity to changes in interest rates. They are more sensitive than shorter-term securities but less sensitive than longer-term securities. Therefore, these securities offer a sweet spot for those investors that are looking to extend/decrease duration at times of changing macroeconomic conditions, provoking a sudden rise or drop of this part of the yield curve ahead of a yield curve’s steepening or flattening.

The 5-year and 7-year US Treasury notes serve as important benchmarks for borrowing and lending in the junk bond space. As a matter of fact, the average maturity for junk bond debt is around 5 years. A sudden rise in yields in this part of the yield curve might be fatal to those cash-strapped companies that might need to raise debt imminently. If spreads spike in the lowest-rated high-yield corporate bonds, volatility might also arise in higher-rated segments of the corporate bond markets. However, considering that a substantial wave of junk bond maturities is not expected until the beginning of 2025, this risk appears to be contained.

Five-year and seven-year note auctions: pros and cons.

The promising news is that both the 5-year and 7-year Treasury yields are currently at appealing levels. If the auction prices align with the current trading yield level, they will mark the second-highest auction yield since 2007 for the 5-year US Treasury auction and the second-highest auction yield on record for the 7-year tenor. Additionally, the risk-reward ratio offered by these tenors is attractive: yields would need to rise above 6% and 5.6%, respectively, within one year to result in a loss.

However, concerns arise when considering the sizes of the upcoming auctions. The US Treasury is set to sell the highest amount of 5-year notes on record, surpassing the peak during the COVID pandemic of $61 billion. While the size of the 7-year auction is below the COVID peak, it still the largest since April 2022. Notably, the When-Issued (WI) tails versus the through are also worth mentioning. According to records dating back to 2017, both tenors have recorded more tails than through, reflecting the high volatility in this segment of the yield curve.