Macro: Sandcastle economics
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Two-year US Treasury notes offer an appealing entry point.
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Sticky consumer and producer prices, a resilient job market, and solid PMI readings are not putting pressure on the Federal Reserve to begin cutting rates. At the same time, the FOMC minutes indicate that the tapering of the Quantitative Tightening is imminent, and it will be discussed in March, ahead of the US Treasury issuing pandemic-like levels of coupon notes and bonds in the second quarter of the year. The recent rise in yields in the front part of the yield curve offers an appealing entry point for investors, as current valuations match the Dot Plot with expectations of three interest rate cuts for this year. However, we remain cautious and see the risk of a bear-steepening of the yield curve triggered by sticky inflation and the issuance of pandemic-like amounts of notes and bonds.
The FOMC minutes show that the tapering of Quantitative Tightening is imminent.
We have learned from the FOMC minutes that policymakers are willing to hold current rates for longer but are starting to worry about systemic liquidity. The minutes say, "In light of ongoing reductions in usage of the ON RRP facility, many participants suggested that it would be appropriate to begin in-depth discussions of balance sheet issues at the Committee's next meeting to guide an eventual decision to slow the pace of runoff. Some participants remarked that, given the uncertainty surrounding estimates of the ample reserve level, slowing the runoff pace could help smooth the transition to that level of reserves or could allow the Committee to continue balance sheet runoff for longer.”
To be clear, bank reserves are ample and exceed $4 trillion. Yet, once that Overnight Reverse Repurchase (ON RRP) facility, which currently amounts to a little over $500 billion, is drained, US reserve balances with the Federal Reserve banks will begin to be depleted. That's when liquidity might start to become stretched, warranting a slower pace of runoff to avoid a liquidity event such as the one in 2019.
An announcement regarding Quantitative Tightening (QT) is likely to come as soon as March because the US Treasury is preparing to issue pandemic-like levels of coupon bonds. If the Federal Reserve doesn't slow down QT, further pressure will be applied on US Treasuries, causing further tightening of financial conditions. Remember that the Bank Term Funding Program (BTFP) is ending in March, and bank liquidity is being withdrawn.
Based on the latest Treasury Borrowing Advisory Committee Advisory (TBAC) recommendations, coupon issuance might rise by $33 billion in Q2. The pace of balance sheet runoff is currently capped at $60 billion a month. Therefore, it’s enough for the Fed to taper QT by $11bn a month to not add pressure in bond markets.
There is no love for duration.
The recent 20-year US Treasury and 30-year TIPS auctions show weak demand for ultra-long maturities. The 20-year US Treasury auction saw a significant drop in indirect bidders to 59.1%, the lowest since May 2021. The bid-to-cover price has also dropped to the lowest since August 2022, resulting in a 3.3bps tail. The day after, the 30-year TIPS auction also tailed by 2.5bp despite paying 2.2% in yield, the highest since 2010. Demand for TIPS was much more solid than the 20-year bonds, showing that investors are still buying inflation protection but demand higher returns in light of uncertainties concerning price pressures.
With the US Treasury looking to sell $1 trillion coupon notes and bonds in the second quarter of the year, we expect ultra-long US Treasury auctions to be the cause of volatility, contributing to a rise in yields in the long part of the yield curve. We remain cautious and don't see scope to add duration beyond the ten years as explained here.
Expectations for interest rate cuts are now matching the Dot Plot.
Sticky consumer and producer prices, a resilient job market, and solid PMI readings have provoked a bear-flattening of the US yield curve. Two-year US Treasury yields (US91282CJV46) rose from 4.11% in January to 4.73% today. Such a move offers an appealing entry point for investors, as current valuations match the Fed dot plot expectations of three interest rate cuts for this year. For two-year US Treasury yields to rise further, inflation must remain sticky in the high 2% or rebound, forcing the Fed to push back on rate cuts. Even if that happens, the 2-year US Treasury offers an appealing risk-reward ratio even when assuming a short-term holding period. Assuming a three-month holding period, yields need to rise by more than 100bps to provide a loss. If the holding period increases to six months, yields need to rise to 6.75% before giving a negative total return. For yields to rise that much in such a short time frame, inflation needs to rebound substantially, forcing the Federal Reserve to hike the Fed Fund rate four more times in only six months, which, at the moment, looks extremely unlikely to happen.
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