Following last week's dreadful 30-year US Treasury auction and the University of Michigan's five- to 10-year inflation expectations rising to the highest since 2011, the bear-steepening trend of the US yield curve remains intact.
As medium-term inflation trends stay anchored and the economy is buoyant, there is no chance for the Federal Reserve to turn dovish even if today's CPI numbers show a sensible deceleration of price pressures.
As the Fed remains higher for longer, the yield curve will bear-steepen, and long-term US Treasury yields will likely continue to rise through the end of the year.
Despite a bond rally that saw 10-year yields dropping from 5% to just below 4.5%, yields remain in an uptrend, and we expect them to rise towards 4.8% in the short term and to test 5% again by the end of the year.
Within this environment, we favour a bond barbell strategy involving the front part of the yield curve, up to three years, and the 10-year tenor.
Moody’s rating outlook change is consistent with higher yields; however, if a downgrade materialises, it can provoke a rally in US Treasuries as markets need to reconsider credit risk.
An ugly 30-year note auction
The rally in US Treasuries following the Federal Open Market Committee (FOMC) rate decision of the first of November proved short-lived. Last week’s three-, 10- and 30-year note auctions revealed bond investors' positioning amid an uncertain macroeconomic environment and monetary policies, and the message was clear: duration is still not appealing.
Last week started with a solid three-year auction, stopping through by 0.1 basis points for the first time after two tailing auctions of the same tenor. The spike of indirect bidders from 56% the previous month to 64.6% mirrors market expectations that the Fed is done with the hiking cycle.
The three-year US Treasury notes are paying 4.83% in yield. For investors to start losing money, yields must increase by more than 100bps, requiring the Fed to hike multiple times in the foreseeable future. As the economy decelerates, such an outcome becomes more and more unattainable.
Demand wasn’t as remarkable at the 10-year US Treasury auction on Wednesday. Despite a considerable spike in indirect bidders from 60.3% to 69.7%, the bid-to-cover dropped to 2.45x, the lowest since June. The auction tailed when issued by 0.8 basis points, showing cracks in demand for duration.
The situation dramatically changed on Thursday when an ugly 30-year US Treasury auction saw a tail of 5.3 basis points, the biggest on record (since 2016). Dealers were forced to buy 24.7% of the issuance, double the recent average and the highest since November 2021. A deep selloff followed and was concentrated in long-term Treasuries, reigniting the bear-steepening of the yield curve.
That was enough to reignite a bear steepening of the yield curve. As Kim Cramer Larsson explains, despite 10-year US Treasury yields indicating a reversal of the uptrend last week after closing below 4.50%, the RSI did not close below the 40 threshold i.e., not confirming a downtrend. At the same time, the future has now resumed downtrend. Yields could move to 4.80%.
Medium-term inflation trends remain concerning
Last Friday, the University of Michigan's five- to 10-year inflation expectations rose to 3.2%, the highest since the 2011 Arab Spring. Despite being merely a survey, it is considered one of the most important inflation expectation measures and market moving. It shows that despite the Fed hiking rates aggressively, inflation expectations remain well anchored and they might continue to feed through price pressures. If people expect prices to rise by 3.2%, businesses will look to raise prices by this amount and workers will seek a comparable salary increase.
It is also key to recognise that the University of Michigan inflation expectations are not the only metrics showing that inflation might be sticky in the long run. The five-year forward inflation swap forward rate has risen significantly since the beginning of the year, and it remains well above the 2% target.
As medium-term inflation expectations remain sticky, is unlikely that the Fed will change narrative, hence we can expect it to stick to the higher-for-longer narrative. If markets believe that a pivot is nearby, investors will position for interest rate cuts, causing a drop in yields across the yield curve and easing financial conditions. As long as inflation remains well above target and real growth well above 0%, it is unlikely that the central bank will want to ease the economy.
Moody’s US rating outlook revision not a game changer
As a cherry on top, Moody’s changed the outlook on the long-term rating of the US from stable to negative on Friday. Moody's is the only rating agency leaving the country with Aaa, while S&P and Fitch have already downgraded it to AA+.
The news did not generate market volatility because investors had enough time to consider what a downgrade might mean for their portfolios this summer when Fitch downgraded the country to AA+ in August, making the US a split-rated AA+ country. We have discovered that it doesn't matter if the country is rated AAA or AA+. Regardless of the rating, financial contracts refer to “AAA or debt backed by the US government”, hence, a downgrade would not provoke a forced unwind of repurchase agreements, loans and derivatives.
Counterintuitively, a third and last downgrade to AA+ might provoke a rally in US Treasuries. Indeed, if the US is rated AA+, companies operating in the US will need to be respectively re-rated. How can companies such as Microsoft and Johnson and Johnson have a better rating than US Treasuries? Would these companies be more likely to repay their debt in a credit event than the US Treasury?
Changes in corporate ratings might provoke volatility in credit markets, favouring US Treasuries in the near term.
A bond barbell
The yield curve will continue to steepen. The bear-steepening of the yield curve will likely continue until the year's end as the economy remains buoyant and the Fed stays on hold. A switch to a bull-steepen is likely next year as the US economy decelerates markedly and inflation expectations continue to drop.
Within this environment, a bond barbell strategy involving the front part of the yield curve up to three years and a 10-year tenor might prove advantageous. In the front part of the yield curve, it is almost impossible to lose money. Two-year US US Treasuries pay 5% in yield, and this position will be in red only if yields rise by 200 basis points or more.
Furthermore, 10-year US Treasuries also offer an attractive risk-reward rating. Considering a one-year holding period, 10-year notes will provide a total return of -2.25% if yields rise by 100bps, but they will pay 12% if yields drop by 100bps, protecting in case of a recession or a credit tail event.
We remain defensive regarding duration and continue to dislike the ultra-long part of the yield curve. Another test will come next week when the US Treasury sells 20-year notes.
Althea Spinozzi is senior fixed income strategist at Saxo Bank