Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Today's 20-year US Treasury auction will serve as a barometer for ultra-long duration.
Althea Spinozzi
Head of Fixed Income Strategy
Summary: If investors are unwilling to increase their portfolio duration, poor demand can reignite the bear-steepening of the yield curve, causing volatility in financial markets. Yet, the upcoming Thanksgiving break might limit volatility as traders prepare to leave for the holidays.
Why is today's 20-year US Treasury bond auction important?
Markets are concerned that today could be a repeat of the ugly 30-year US Treasury auction at the beginning of the month. At that time, dealers were forced to buy 24.7% of the amount issued, almost double what they had to absorb on average since the beginning of the year for auctions of the same tenor. Primary dealers must buy the debt not purchased by other bidders during a US Treasury auction. Therefore, an increase in their take is synonymous with deteriorating demand.
November's 30-year auction tailed When Issued by 5.3 basis points, the most on record (since 2016), provoking a deep selloff in the bond and stock market. Although it is unclear whether a ransomware attack on ICBC weakened demand, it's key to note that indirect bidders were sensible lower, making issues concerning ICBC unlikely to be the only contributors to deteriorating demand. It is more likely that declining demand was caused by the sudden drop in yield, which saw 30-year bonds getting almost 50bps more expensive from their peak at 5.14%.
That brings us to today, as the 20-year US Treasury note pays a yield of 4.8%, roughly 45bps below the high yield at October's auction.
It will be key to see whether investors are willing to extend the duration at current levels or are demanding a higher yield.
Nonetheless, if demand increases, it could give the green light to bond bulls, and the yield curve can further bull-flatten, pushing 10-year yields towards 4%. Yet, a rally might be contained. From September until today, leveraged funds have reduced their short positions in 20-year T bond futures. Therefore, today, a solid 20-year US Treasury auction might not trigger enough short covering to push 10-year yields below support at 4.36%.
Why do investors dislike 20-year US Treasuries?
Markets usually dislike 20-year U S Treasury bonds because they are the less liquid tenor in the US Treasury yield curve besides proving high duration risk. That's why the 20-year is one of the cheapest bonds within the Treasury markets, now paying 4.83% in yield, while the 10- and 30-year Treasuries pay 4.46% and 4.62%, respectively.
The 20-year tenor was reintroduced in 2020 amid the COVID-19 pandemic to increase the Treasury's financing capacity over the long term while funding the government at the least possible cost to taxpayers over time. Before that, auctions for this tenor were discontinued in 1986 because of the higher funding cost compared to other yield curve maturities. The same argument can be made today; however, with the yield curve still slightly inverted, 20-year US Treasuries still pay a lower yield than the 2-year notes.
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