Head of Fixed Income Strategy
Summary: Wednesday's 20-year US Treasury notes and Thursday’s 30-year TIPS auctions might be pivotal ahead of Jackson Hole on Friday. With Japanese investors returning home, the US Treasury increasing bills and bonds supply, and Quantitative Tightening (QT) still running, investors might find little reason to buy long-term US Treasuries. In August, many traders are not at their desks, leaving those in the office reluctant to add duration to their portfolios. Yet, the above-average yields offered by these issuances might be enticing for whom is speculating the Federal Reserve might be done fighting against inflation.
Tomorrow the US Treasury will sell $16 billion in new 20-year notes (US912810TU25), the infamous tenor that was re-introduced in 2020 after being discontinued in 1986.
Investors buying into the first 20-year notes issued in June 2020 (US912810SR05) have seen their mark-to-market value falling slightly over 101 to 60 as the Federal Reserve hiked interest rates to fight inflation. The sale of these notes has sometimes sparked volatility in the bond market. During last October’s 20-year auction, poor demand accelerated the US Treasuries selloff. In the three days following the auction, the 20-year yield spiked by 30bps, and 10-year US Treasuries rose by 20bps. The risk for the same to happen this time is high, as tomorrow's auction sale has increased by $1 billion, and many traders are either on vacation or reluctant to add duration to their portfolio before the Jackson Hole meeting.
However, there is a chance for the opposite to happen. Indeed, 20-year notes offer 20 basis points over 30-year US Treasuries, paying 4.6% in yield. The premium 20-year notes pay over a longer duration represent an illiquidity premium. Indeed, there are much fewer 20-year notes in circulation than 30-year notes. Yet, such a premium might be enticing for those investors anticipating the Fed to end its hiking cycle and looking for protection in case of a recession.
The new 20-year notes (US912810TU25) will pay a coupon of 4.5%. If investors secure it at a yield of 4.6% and hold them until the end of 2024, they will lose -0.5% if 20-year yields go to 5.2% and gain 14.23% if yields fall to 4%.
Tomorrow's bidding metrics for the 20-year US Treasury auction will be critical. Indirect bidders below 67% might indicate a lack of foreign investors' demand, hinting at Japanese investors' repatriation spurring additional bearish sentiment in US Treasuries. On the other hand, indirect demand above 75% might signal a return of duration appetite among investors despite the increase in auction sizes and QT running in the background.
Will investors see scope to buy inflation protection that far out into the future? In the secondary market, 30-year TIPS pay 2%. At this level, it would be the highest yield recorded by this tenor in an auction since 2011. Yet, it's fair to note that the US Treasury did not increase the auction size of long-term TIPS on purpose: demand has never been that great, and it should decrease as the market thinks that the Fed has squashed inflationary pressure. Therefore, although it may not be as volatile as the 20-year note sale, it's worthwhile to follow this auction as well, as it might still be the cause of volatility and it provide information about investors' long-term inflation expectations.
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