Insights into this week's US Treasury auctions: 20-year U.S. Treasury bonds and 10-year TIPS.

Summary:

• Expectations on this week's 20-Year bonds and 10-Year TIPS auctions: The auction for 20-year bonds is expected to attract weak demand due to political uncertainties, lower liquidity, and less favorable yield curve positioning. In contrast, the 10-year TIPS auction is expected to be more balanced due to attractive real yields and potential interest rate cuts.
• Demand at the 20-year bond auction is crucial to understand duration appetite: Demand at the 20-year bond auction is crucial for gauging investors' appetite for longer durations, particularly after last week's weak interest in the 30-year tenor. If demand for the 20-year bonds increases, it could signal the onset of a short-term bond rally ahead of the Fed's anticipated interest rate cuts, despite ongoing economic and political uncertainties.
• Impact on Bond Markets: The results of this week's Treasury auctions will influence the bond market, potentially causing 10-year Treasury yields to break below their 4.18% support if demand for longer durations increases. If demand at the 20-year auction is weak, it could lead to a rise in yields across long-term tenors, causing 10-year U.S. Treasury yields to reject support at 4.18%.

Anticipated Market Dynamics.

The US Treasury is set to auction $32 billion worth of coupon-bearing Treasuries this week, divided between 20-year Treasury bonds and 10-year Treasury Inflation-Protected Securities (TIPS). So far in July, $108 billion in coupon redemptions have bolstered demand from direct bidders at recent Treasury auctions, resulting in strong bidding metrics for the 2- and 10-year tenors. With an additional $122 billion in coupon redemptions due by the end of the month and a significant slowdown in quantitative tightening (QT), upcoming auctions are expected to be well received despite signs of decreasing duration appetite among indirect bidders.

Last week, indirect bidders were selective at the Treasury auctions, leading to a drop in demand for the 30-year tenors and causing the largest tail in a 30-year Treasury auction since January 2023. As we are just midway through July, investors are anticipating another busy week of auctions, with 2-, 5-, and 7-year tenors to be issued next week, totaling approximately $183 billion. In light of the upcoming supply, indirect bidders might continue to be selective, particularly avoiding the least favored tenor in the yield curve, the 20-year tenor. Additionally, demand for 10-year TIPS remains uncertain as the Federal Reserve prepares to begin a rate-cutting cycle due to a pick-up in the disinflationary trend, which might decrease the appetite for these instruments as investors might prefer to secure a fixed coupon on their investment.

It's unlikely that this week’s 20-year US Treasury auction will attract solid demand due to several factors. Political uncertainty, particularly the potential for a Trump victory reigniting inflation fears, could deter investors. Additionally, the 20-year bond's lower liquidity compared to 10- and 30-year bonds makes it harder to. It lacks benchmark status, making it less attractive for financial instruments and economic indicators. The bond also sits poorly on the yield curve, offering neither the higher yields of 30-year bonds nor the shorter duration risk of 10-year bonds. For Japanese and European investors, the hedged yields of 20-year bonds are less appealing compared to their domestic or other U.S. options.

In contrast, the 10-year TIPS auction appears more balanced. Despite disinflationary pressures, TIPS offer a real yield of 1.9%, the highest since the Global Financial Crisis, making them attractive. Expectations of interest rate cuts by the Fed enhance the appeal of TIPS, as their interest rate component should gain value even if the inflation component diminishes. Political uncertainties, while present, could result in elevated real yields, maintaining investor interest in these securities.

What implications does this hold for bond markets?

The US Treasury auctions occur during a week with light economic data but a busy schedule for Federal Reserve speakers. Although the market does not anticipate a rate cut this month, even after Federal Reserve Chair Jerome Powell's interview with David Rubenstein where he emphasized that second-quarter economic data has bolstered policymakers' confidence in reaching the central bank's 2% inflation target, investors will be closely monitoring Waller's speech. Indications that interest rate cuts might be imminent could increase demand for longer durations. The first sign of this duration extension would be strong bidding metrics at this week's 20-year US Treasury auction, contrasting with last week's weak 30-year Bond sale. If this scenario unfolds, 10-year US Treasury yields might break below support at 4.18%, potentially finding resistance next at 3.78%.

It's important to note that even if long-term yields drop, long-term U.S. Treasuries remain vulnerable to a potential economic re-acceleration, especially with premature interest rate cuts and a possible Trump victory. In the short run, duration might perform well due to the current macroeconomic narrative. However, we anticipate the term premium to rise due to fiscal concerns and the long-term neutral rate to remain elevated, establishing a floor for the long end of the yield curve as described here. Therefore, in case of weak bidding metrics at this week’s 20-year U.S. Treasury auction, long term yields might resume their rise, causing 10-year yields to reject support at 4.18%.