Bond Traders Weekly Outlook: Two Year Note Underperforms After Stellar Treasury Auction Week

U.S. Treasuries ended the week lower, giving back their gains from earlier in the week. Friday’s retreat left yields on 10s and 30s little changed for the week while the 2-yr note underperformed. The 2-yr Treasury note yield rose seven basis points to 3.98% this week and the 10-yr note yield rose one basis point to 3.46%. The 2s10s spread compressed by six basis points to -52 bps. The U.S. Treasuries auction were all strong this week. A $21 billion 30-yr bond auction met solid demand and was rated an A which followed lower than expected CPI and PPI reports for April. We also saw a $35 bln 10-yr note sale which met solid demand just under a stellar and a $40 bln 3-yr note sale found stronger interest.

Crude oil lost $1.36, or 1.9%, for the week, while the U.S. Dollar Index rose 0.6% to 102.71 Friday, reclaiming its 50-day moving average (102.51). The Index gained 1.4% for the week.

Hungry Bond Traders

Understandably, aware of past Fed behavior markets are conditioned for loose conditions. They expect Fed loosening measures to reverse any meaningful tightening, hence constant flipping between end of inflation and hawkish Fed speaks trades.

There is a firm belief the Central Banks are blindly raising rates because ‘they have to’ and the consequences will be dire, furthermore that the US Administration is bumbling along with damaging decisions one after the other.

Weekly Recap

The 2-yr Treasury note yield rose seven basis points to 3.98% this week and the 10-yr note yield rose one basis point to 3.46%. The 2s10s spread compressed by six basis points to -52 bps.

The U.S. Treasuries auctions were all strong this week. A $21 billion 30-yr bond auction met solid demand and was rated an A which followed lower than expected CPI and PPI reports for April. We also saw a $35 bln 10-yr note sale which met solid demand just under a stellar and a $40 bln 3-yr note sale found stronger interest.

Bond auctions last week:

Solid Demand at US 30-year Treasury Bond Auction Following April CPI and PPI Data
Weak Demand in 10-year U.S. Treasury Bond Auction Following CPI Report
Steady 3-Year Treasury Bond Auction with High yield 3.810% Right on When Issued Pricing

Money Market Flows

  • (Investment-grade bond funds posted inflows of $1.428 billion, while junk bond funds reported outflows of $1.202 billion (from Lipper).
  • Total money market fund assets rose $18.3bn to a record $5.328 TN, with a nine-week gain of $434bn. Total money funds were up $827bn, or 18.4%, y-o-y.
  • Total Commercial Paper added $2.4bn to $1.146 TN. CP was up $34bn, or 3.0%, over the past year.

Yield Watch

Friday/Week

  • 2-yr: +8 bps to 3.98% (+7 bps for the week)
  • 3-yr: +12 bps to 3.67% (+2 bps for the week)
  • 5-yr: +9 bps to 3.45% (+3 bps for the week)
  • 10-yr: +7 bps to 3.46% (+1 bp for the week)
  • 30-yr: +3 bps to 3.78% (+2 bps for the week)

U.S. Treasuries finished April with solid gains across the curve following the release of the Bank of Japan’s first policy statement under Kazuo Ueda. The BoJ made no changes to its ultra-loose policy, but it replaced a pledge to keep rates at or below current levels with guidance for continued yield curve control with an aim of achieving the price stability target.

Key Rates and Spreads

Rates

  • 10-year Treasury bonds 3.43%, up +0.03% w/w (1-yr range: 1.66-4.25) (12 year high)
  • Credit spread 2.21%, unchanged w/w (1-yr range: 1.76-2.42)
  • BAA corporate bond index 5.64%, up +0.03 w/w (1-yr range: 5.00-6.59) (10 year+ high)
  • 30-Year conventional mortgage rate 6.50%, down -0.09% w/w (1-yr range: 5.05-7.38) (new 20 year high)

Yield Curve

  • 10-year minus 2-year: -0.53%, down -0.05% w/w (1-yr range: -0.86 – 1.59) (new 40 year low)
  • 10-year minus 3-month: -1.76%, up +0.06% w/w (1-yr range: -1.17 – 2.04) (new low)
  • 2-year minus Fed funds: -1.09%, up +0.08% w/w
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity (T10Y2Y)

Two Year Treasury Volatility was Historic in the First Quarter of 2023

  • Two-year Treasury yields began 2023 at 4.43% then fell to 4.10% by February 2nd.
  • Yields then surged almost 100 bps to trade to 5.07% on March 8th. Volatility was on steroids.
  • Yields were down to 3.71% intraday on the 15th, only to rally back to 4.25% on the 17th.
  • They sank to a low of 3.63% on the 20th, back up to 4.25% on the 22nd,
  • Then down to 3.55% on the 24th
  • Ended the quarter at 4.03%.
  • The yield on the 2-year Treasury fell to 4.06%, down 3.7 basis points on Friday and posting the biggest monthly drop since January 2008, in March the yield fell 73.5 basis points. Its first quarterly retreat in eight quarters.
  • The yield on the 10-year Treasury was at 3.491%, off 5.9 basis points, and recording its sharpest monthly fall since March 2020.
  • The yield on the 30-year Treasury declined to 3.688%, down 5.7 basis points, while setting its biggest monthly decline since January.

US corporate bond spreads over US Treasuries and how they have widened as cyclical risk have risen but are well shy of the wide spreads recorded during the early part of the pandemic, let alone the GFC. To label this as a severe credit crunch would be extreme.

10 Year Note Technical Analysis via KnovaWave

Highlights – Federal Reserve

  • F
  • Federal Reserve Credit declined $43.0bn last week to $8.461 TN.
  • Fed Credit was down $440bn from the June 22nd peak.
  • Over the past 191 weeks, Fed Credit expanded $4.734 TN, or 127%.
  • Fed Credit inflated $5.650 TN, or 201%, over the past 548 weeks.
  • Fed holdings for foreign owners of Treasury, Agency Debt increased $8.7bn last week to a near eight-month high $3.382 TN.
  • “Custody holdings” were down $41bn, or 1.2%, y-o-y.

End-of-week market pricing had a 13% probability of a 25-bps hike at the FOMC’s June 14th meeting – pricing in a 5.10% implied rate. Yet markets are not backtracking whatsoever on pricing in a dovish pivot. Markets ended the week pricing a 95-bps rate reduction by the January 31, 2024 meeting (over about seven months).

Federal Reserve Raises Rates 25bps as Expected, Removes Additional Firming May be Appropriate

Jay Powell’s press conference was ‘uncontroversial’. We did see some contrition from him “We are committed to learning the right lessons from this episode and will work to prevent events like these from happening again.”

A bit late given we have seen indefensible mistakes made in pathetic bank regulation. We had inflation mismanagement that is at risk of historic failure. Banking instability adds to downside economic risks, containing inflation leant the bank, at tleast in this meeting to err on the side of overing crushing the economy. Powell repeatedly reminds the risk of repeating past mistakes, where Fed inflation fights ended prematurely.

The FOMC meeting came in the midst of chaos. There was a strong case for the Fed to put off another rate increase. The unfolding banking crisis ensures tighter credit for an economy already downshifting. The case for hiking rates was equally compelling. Inflation remains elevated, with recent data consistently pointing to sticky price pressures. Friday’s strong payroll data, including NFP 253,000 jobs added and a 0.5% (4.4% y-o-y) gain in Average Hourly Earnings confirmed unrelenting labor market tightness.

Bloomberg’s Mike McKee: “Markets have priced in rate cuts by the end of the year. Do you rule that out?”

Chair Powell: “We on the Committee have a view that inflation is going to come down, not so quickly, but it’ll take some time. And in that world, if that forecast is broadly right, it would not be appropriate to cut rates, and we won’t cut rates. If you have a different forecast – markets have been from time-to-time pricing in quite rapid reductions in inflation – we’d factor that in. But that’s not our forecast. And, of course, the history of the last two years has been very much that inflation moves down [gradually]. Particularly now, if you look at non-housing services, it really, really hasn’t moved much. And it’s quite stable. So, we think we’ll have to – demand will have to weaken a little bit and labor market conditions may have to soften a bit more to begin to see progress there. And, again, in that world, it wouldn’t be appropriate for us to cut rates.”

Central Bank Watch – Deluge of BOE, ECB and Fed Speakers including Powell and Bernanke

Highlights – Mortgage Market

  • Freddie Mac 30-year fixed mortgage rates declined six bps to 6.43% (up 113bps y-o-y).
  • Fifteen-year rates dropped 10 bps to 5.75% (up 127bps).
  • Five-year hybrid ARM rates sank 23 bps to 5.73% (up 175bps).
  • Bankrate’s survey of jumbo mortgage borrowing costs had 30-year fixed rates down a basis point to 6.87% (up 132bps).
Mortgage News Daily February 17, 2023

Global Bond Watch

“Government bond prices around the world are moving in tandem, reducing investors’ ability to diversify their portfolios and raising concerns of being blindsided by market gyrations. Correlations between currency-adjusted returns on the government debt of countries such as the U.S., Japan, the U.K. and Germany are at their highest level in at least seven years, data from MSCI showed, as central banks around the world ramp up their fight against inflation.”

October 10 – Reuters (Davide Barbuscia)

Major Benchmark 10-year Bond markets

Bond Market Performance 2023

Major 10-year Bonds/Notes

Highlights – European Bonds

Ten-year government yields down significantly.

  • Greek 10-year yields dipped two bps to 4.00% (down 57bps y-t-d).
  • Italian yields slipped a basis point to 4.18% (down 52bps).
  • Spain’s 10-year yields declined two bps to 3.36% (down 16bps).
  • German bund yields slipped two bps to 2.28% (down 17bps).
  • French yields declined two bps to 2.86% (down 12bps).
  • The French to German 10-year bond spread was little changed at 58 bps.
  • U.K. 10-year gilt yields were unchanged at 3.78% (up 11bps).

This all happened quickly…. just months ago we had:

German 10-Year Bunds at Weakest Level since July 2011 as Yield Curve Inversion Deepens

Highlights – Asian Bonds

  • Japanese 10-year “JGB” yields declined three bps to 0.39% (down 3bps y-t-d)

“The unprecedented monetary easing by the Bank of Japan over the past decade has reshaped the nation’s lenders, from their asset holdings to loan income. That may be about to change as the central bank prepares to take on a new chief next month… The most notable case is Japan Post Bank Co., a unit of a former state-run mail services giant, which manages most of almost $2 trillion of assets in its securities portfolio. Where it once invested as much as 80% of its money in JGBs, this now accounts for less than 20%. Instead, the bank has rapidly built up its holdings of foreign bonds and other securities to 78 trillion yen ($572bn), accounting for about 35% of its entire portfolio.”

March 5 – Bloomberg (Taiga Uranaka)
Deja Vu as Dollar Yen Soars After Bank of Japan Keeps Monetary Policy Steady, No Change to JGB Yield Band

Key US Bond Auctions

Inflation Matters

Inflation with Henry Kaufman

Kaufman is the legendary chief economist and head of bond market research at Salomon Brothers is someone who knows Inflation.  Henry Kaufman in an interview with Bloomberg’s Erik Schatzker Jan 14, 2022:

 “I don’t think this Federal Reserve and this leadership has the stamina to act decisively. They’ll act incrementally. In order to turn the market around to a more non-inflationary attitude, you have to shock the market. You can’t raise interest rates bit-by-bit.”

“The longer the Fed takes to tackle a high rate of inflation, the more inflationary psychology is embedded in the private sector — and the more it will have to shock the system.”

“‘It’s dangerous to use the word transitory,’ Kaufman said. ‘The minute you say transitory, it means you’re willing to tolerate some inflation.’ That, he said, undermines the Fed’s role of maintaining economic and financial stability to achieve ‘reasonable non-inflationary growth.’”

Inflation, Disinflation

US Core PCE Inflation Held Steady at Persistently High Levels in March
US Producer Price Inflation Fell Again in March, -0.5% m/m vs 0.0% Expected
Consumer Inflation in March Eases, Higher Shelter Prices Offsetting Fall in Energy Costs
FAO World Food Price Index Fell in March for Twelfth Consecutive Month

The rubber is meeting the road as the trifecta of rising interest rates, the Russian invasion of Ukraine and surging costs continues to weigh, this has been no surprise to us here and shouldn’t have been to the market and PTB. You can only play with fire for so long before you get scorched!

With all the redirection of blame at the Fed about inflation one has to understand it is a global phenomenon outside the Fed’s Control. With the war drums louder than ever the supply chain issues are out of control. The Federal Reserve is not in control of global energy and commodities prices.

Everything points to powerful inflationary dynamics and a Federal Reserve so far “behind the curve.”

Instability is pronounced, credit defaults are on track to rise in North America, Europe, Asia, and Australia, according to a survey by the International Association of Credit Portfolio Managers. The economic slump is likely to occur later this year or in 2023, according to the survey.

Global Bonds 2022 Performance

10 Year Bonds – Americas 2022 Performance

10 Year Bonds – Europe 2022 Performance

10 Year Bonds – Asia 2022 Performance

10 Year Bonds – Africa 2022 Performance

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Sources: Scotia Bank, TC

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