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

Summary:

• This week’s two- and five-year auctions are likely to draw solid demand. Despite their record large auction size, unchanged from the month of April, the risk-reward offered by these tenors is favorable amidst the macroeconomic backdrop.
• Comparing the bidding metrics of the 7-year auction to those of the 5-year auction is crucial for understanding investors' appetite for duration. The two tenors are offering a similar risk-and reward, yet the 7-year notes bring higher duration risk. It’s key to see whether bidders are looking to extend duration as policymakers display no sign to cut interest rates soon.
• Two-year yields are likely to continue trading within the 4.7% - 5.05% range until there is clarity on the future of inflation.

Anticipated Market Dynamics:

The US Treasury is set to auction $211 billion worth of coupon-bearing US Treasuries this week spanning 2-, 5-, and 7-year tenors and including a 2-year floating rate note auction not discussed in this analysis. May have accounted with it $286 billion in coupon redemptions, bolstering demand and resulting in robust bidding metrics until now despite ongoing quantitative tightening (QT) operating at full speed this month, with plans for a slowdown next month.

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 last month’s record high levels, the notes’ risk-reward profile appears compelling amidst a continuously evolving macroeconomic landscape. This should position the notes favorably, even though they cannot fully capitalize on this month’s redemptions, as $125 billion in 3-, 10-, and 30-year notes have already been issued this month.

In contrast, the proposition presented by the 7-year notes is different, carrying the highest duration and paying the lowest yield of the three. Extending duration at a time when inflation remains persistent suggests a directional bet on swift disinflation pressures, likely leading to early and aggressive rate cuts. With Federal Reserve members recently stating that they do not foresee rate cuts until inflation is no clear path to the 2% central bank target, investors might be reluctant to extend their portfolio’s duration.

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 take place. The economy is cooling, with consensus expecting the second reading for Q1 GDP to come in at 1.3%, down from the prior reading of 1.6%, and the Fed will proceed to reduce the pace of QT next month. These factors should provide a tailwind for US Treasuries. However, if inflation shows signs of stickiness, or even worse, a rebound, it is unlikely that investors would want to hold duration in their portfolios.

Even with solid demand at this week’s auctions, we expect 2-year yields to continue trading within the 4.7% - 5.05% range until there is clarity on the future of inflation. Ten-year yields remain in an uptrend, and a weak 7-year auction might push them towards resistance at 4.7%, while a strong auction could see them falling to test support at 4.3%.