News
Fed Rate Cut Expectations Boost US Treasury Rebound
Last week, the rekindled expectations of a Federal Reserve rate cut fueled a rebound in the U.S. Treasury market, but investors seem to be waiting for more evidence to determine whether the rebound can be sustained. This week, the U.S. Treasury market will face the test of a new round of Treasury issuance.
Reignition of Fed Rate Cut Expectations Boosts U.S. Treasury Market
Last Friday, data released by the U.S. Department of Labor showed that the U.S. April non-farm employment data significantly underperformed expectations, with the unemployment rate rising and wage growth slowing down. Coupled with the Fed's surprise "dovish" stance earlier last week, market expectations for a Fed rate cut within the year have rapidly heated up again. The most sensitive to changes in interest rate expectations are undoubtedly U.S. Treasury traders. The U.S. 10-year Treasury yield, known as the "anchor of global asset pricing," touched its lowest in two weeks at 4.453% last Friday, falling 6.9 basis points to close at 4.501%. Over the past week, this benchmark yield has累计 fallen by 16.7 basis points, marking the largest weekly decline so far this year. The 2-year U.S. Treasury yield, which is more sensitive to interest rates, also touched its lowest in three weeks at 4.716% last Friday, ending at 4.809%. This yield fell 19 basis points last week, marking the largest weekly decline since early January.
Following the non-farm employment report, the FedWatch tool from the Chicago Mercantile Exchange showed that the probability of a Fed rate cut in September has risen to 77%, significantly higher than the approximately 60% on the previous Thursday. Swap contract pricing also reflected this, with the expected rate cut for the year rising from about 41 basis points before the report to about 50 basis points. This indicates that expectations for two rate cuts within the year are fully returning. Looking ahead to this week, several Fed officials will take turns speaking after the "quiet period" ends, and their statements will further influence market judgments on the Fed's interest rate prospects.
Advertisement
At the same time, this week, the U.S. Treasury market will usher in a new round of auctions. A $67 billion auction of 10-year and 30-year U.S. Treasuries will test investor demand for long-term bonds. In addition, as part of the so-called quarterly refund auction, the U.S. Treasury will also auction $58 billion in 3-year U.S. Treasuries.
Some analysts believe that although there are signs of deceleration in certain areas of the U.S. economy, inflation remains a tricky issue, which may limit the Fed's ability to cut rates and mean that U.S. Treasury yields may continue to hover within their recent range.
Mark Lindbloom, a portfolio manager at Western Asset Management, said that the latest non-farm employment report and comments from Fed Chairman Powell "have given the market a sigh of relief, but we would never predict that U.S. Treasury yields could drop by 50 to 100 basis points all at once."
Ryan Swift, a U.S. Treasury strategist at BCA Research, expects that "in the coming months, the 10-year U.S. Treasury yield will remain within a wider trading range, with the upper limit being the cyclical peak touched in October last year, and the lower limit being the low touched earlier this year (3.80%). Ultimately, the yield will break through the lower limit of this range, but before that, investors need to see weaker labor market data."
Investors Still Favor Steepening Yield Curve Trades
In addition to being cautious about whether the overall rebound in the U.S. Treasury market can be sustained, U.S. Treasury investors also favor steepening yield curve trades in their specific trading strategies. In their view, although the rekindled expectations of rate cuts are beneficial to U.S. Treasuries of all maturities, and the current 4.5% yield on 10-year U.S. Treasuries is at its highest level since 2007, if inflation continues to be higher than the Fed's target, and uncontrolled U.S. government spending leads to an increase in the scale of long-term U.S. Treasury auctions again, neither 10-year nor 30-year U.S. Treasuries will be very attractive to investors.Generally speaking, if the Federal Reserve begins to lower interest rates and the market further prices in a more accommodative outlook due to weaker data, the yield on the 2-year U.S. Treasury note tends to decline more rapidly than the benchmark 10-year U.S. Treasury yield. Unless inflation, along with other economic data, begins to slow down in tandem, the rally in the 10-year U.S. Treasury notes will not be able to keep pace with short-term U.S. Treasury notes. However, the current reality is that the data remains mixed. Contrary to last Friday's employment data, another report last week indicated that price pressures in the U.S. manufacturing and service sectors remain stubbornly high.
George Catrambone, head of fixed income at DWS Americas, has a preference for 2-year U.S. Treasury notes. Swift also believes that the outlook for short-term bonds such as 2-year and 5-year U.S. Treasury notes is better than that for long-term bonds. Jennifer Karpinski, Managing Director at Jennison Associates, also favors employing a "steepening trade strategy" in investment portfolios, increasing holdings in 2-year, 3-year, and 5-year U.S. Treasury notes while reducing holdings in 10-year U.S. Treasury notes. "At present, it is still difficult to determine when long-term U.S. Treasury notes will become more attractive," she admits.
Another factor leading investors to bet on a steeper yield curve is that, as long-term U.S. Treasury yields become more sensitive to inflation stickiness, U.S. Treasury investors start to demand more compensation for holding long-term yields, i.e., they require a higher term premium. Currently, the term premium, calculated based on the New York Fed model, is still negative. Investors believe that, with the Federal Reserve's exit and in an environment of monetary normalization, the term premium should be positive. Karpinski states, "We have not yet seen the long-term premium return to historical normal levels, but we do believe it will return to normal." She adds, "In terms of quarterly refund auctions, the (U.S.) Treasury has not yet increased the auction size of long-term U.S. Treasury notes, but if, over time, this size does indeed rise, it will also become another factor in further pushing up the yields on long-term U.S. Treasury notes."
Leave a comment