US Treasury auctions on the back of the US CPI might offer critical insights to investors.

Summary:

- With the Bank of Japan looking to normalize monetary policy, foreign investors may begin to buy fewer US Treasuries.

- Inflation trumps all other macroeconomic metrics. If investors perceive inflation to remain sticky, they will demand a higher return on US Treasuries despite the economy deteriorating.

- US Treasury coupon auction sizes have increased to pandemic-like levels, forcing primary dealers to absorb more of these notes and bonds. That spurs volatility in secondary bond markets.

Inflation trumps all other data.

With Federal Reserve members entering the blackout period before next week’s Federal Reserve meeting, markets’ attention turns towards the US CPI being released today and PPI data on Thursday. Economists expect monthly CPI numbers to have risen by 0.4% in February due to a rise in gas prices from the previous month. Yet, headline CPI YoY numbers are expected to remain flat at 3.1% compared to last month, while core CPI numbers are expected to fall from 3.9% to 3.7% YoY. Despite the FED putting more weight on PCE numbers, a surprise on the upside to today's CPI markets could still spark a selloff across tenors in US Treasuries.

Yesterday's New York Fed Survey of Consumer Expectations showed that inflation trumps all other economic metrics. Indeed, the 5-year inflation expectations rose in February to 2.9% after bottoming out at 2.5% in December and January. At the same time, the report showed signs of cooling in the labor market. The probability of losing one's job in the next year rose to 14.5%, the highest since April 2021. Yet, bonds reacted by selling off across tenors, and the yield curve bear-flattened, with two-year US Treasury yields rising by 6bps and 10-year yields closing the day 2bps higher. That is a sign that until inflation is not clearly under control, the bond market US Treasury yields will remain volatile.

On the back of the New York Fed Survey, the US Treasury sold $56 billion 3-year notes (US91282CKE02), receiving solid demand. The notes were priced at a high yield of 4.256%. Indirect bidders rose to 70%, the highest since August last year. Primary dealers had 14.4% of the issuance, the lowest since August, which was also the lowest on record.

It’s important to note that the 3-year US Treasury notes carried low duration, providing a win-win scenario to investors, even if yields resume to rise. Indeed, assuming a holding period of six months, the yield of the 3-year US Treasury would need to rise above 5.20% before providing a negative return. Such a dramatic rise in yields could only be justified if the Federal Reserve resumes its hiking cycle, which is unlikely ahead of the US elections.

Ten- and thirty-year US Treasury bond auctions: what to look for.

This week, the US Treasury will sell $39 billion 10-year notes and $22 Billion 30-year bonds. The size of these auctions is in line with pandemic averages. The difference is that today, traditional buyers are no longer there. Indeed, the Federal Reserve is a net seller of US Treasuries, while US banks have a problem in dumping low-coupon US Treasuries. Treasury auctions are increasingly relying on indirect bidders to absorb a significant part of this auction. While indirect bidders represent investors who don’t have a direct line with the US Treasury to participate in these auctions, foreign investors constitute a considerable part of such bidders.

Bidding metrics at today and tomorrow's US Treasury coupon auctions may answer two critical questions:

• Will investors look to increase their portfolio duration, although above-target inflation remains underpinned?
• Will foreign investors, particularly Japanese investors, continue to buy US Treasuries even as the Bank of Japan looks to normalize monetary policy?

If bidding metrics weaken rather than strengthen, it might be a sign that bond-term premium is poised to rise. While not negative, term premium rose to 40bps in the last quarter of 2023 as investors demanded a higher return to hold US Treasuries.

If inflation remains sticky, or foreign investors opt for domestic investment securities over US Treasuries, term-premia might rise again, forming a bear market within long-dated bonds.

The gradual increase in primary dealers' take at 10-year auctions may point to sluggish investor demand amid an increase in auction issuance size. That's why we remain cautious about duration while we favor the front part and the belly of the yield curve.