Macro: Sandcastle economics
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From unicorns to ponies: US Treasuries are losing their luster
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Opposite to what happened in 2011, Fitch's US rating downgrade might prove to be bearish for US Treasuries for a straightforward reason: why would investors buy ten-year US Treasuries (AA+) at 4% when USD hedged ten-year Bunds (AAA) pay 4.25%? Not only that, but the "soft-landing" scenario and larger US treasury auctions spell for higher yields. Ten-year yields are likely to head towards 4.3%, while two-year yields are likely to test resistance again at 5.04%. Yet, the rise in yields will be stopped abruptly when something breaks, which is more likely to happen as yields continue to soar.
Fitch cut the US rating downgrade because of an “expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to 'AA' and 'AAA-rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions." Such a decision would put pressure on any country's government bonds. However, it did not trouble US Treasuries; why?
The answer to that question relates to the fact that US Treasuries are notoriously regarded to be a safe haven. A deterioration of the US economy implies higher risks in the corporate space. Therefore, investors would sell risky assets and flee to safety. Guess where they would find safety? In US Treasuries!
Although Fitch’s downgrade differs in many ways from the 2011 S&P downgrade, it makes sense to revisit this event to understand what has happened in the past.
On August the 5th, 2011, a few days after Congress agreed to increase the US debt ceiling solving a debacle going on for months, S&P downgraded the US government rating from AAA to AA+. US Treasuries rallied across maturities, with 10-year dropping by 38bps by the end of August.
Back then, market participants understood the considerable problem the market would run into if another rating agency were to cut the US rating, pushing US debt into AA+ territory rather than AAA. That’s why since then, contracts such as repurchase agreements, loans, and derivatives have been written to include “debt backed by the US government.” This is why yesterday’s Fitch credit downgrade will not force the unwinding of such contracts, removing a lot of pressure that otherwise might have been applied to US Treasuries.
The most significant risk the market faces in the upcoming weeks is the reconsideration of credit risk in financial markets. If the US economy is deteriorating, that's bad news for the US corporate space. Therefore, some investors might see scope to sell risky assets to flee to safety, which they can find where? In US Treasuries!
This time around, a rating downgrade might spell troubles for US Treasuries
However, This time around, the US Treasuries rally might not last. Indeed, several factors contribute to a bearish US Treasury outlook in the upcoming weeks:
(1) The German Bund offers better risk and reward. While US Treasuries were mostly flat following the Fitch rating downgrade, Bunds rallied. The reason for such outperformance is simple: once hedged against the USD, German Bunds (AAA) pay a yield of 4.25%, 25bps points higher than their US peers (AA+). Therefore, why would risk-sensitive investors stay in US Treasuries when they can get a better payoff in Bunds? That could add to the US Treasury's weakness in the next few weeks.
(2) The “soft landing” scenario translates into higher rates, which will trouble the US economy. The soft-landing fairy tale has short legs for one simple reason: if the economy remains solid, but core inflation is expected to end the year at 4.2%, the Federal Reserve might need to continue to hike interest rates. The hiking pace might be slower, but the peak rate might be much higher than the market forecasts. Long-term yields might continue to soar, putting more pressure on the economy. In other words, US Treasury yields will continue to soar until something breaks. At that point, the Federal Reserve will not be able to hold rates at high levels for long, and a bull bond market might form.
(3) Higher bond issuance will also translate into higher yields. The Treasury has announced today that it will lift refunding auctions by $7 billion to $103 billion, boosting auction sizes for all nominal bonds. That builds upward pressure for yields across maturities, painting a bearish picture for US Treasuries.
US Treasuries yields: what's next?
Ten-year yields are testing resistance at 4.08% and are likely to break above it to continue to soar toward 4.31%
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