Auction Dynamics Augurs Well for Long 2Y Short 5Y SpreadIn US Treasury Auctions, the Bid to Cover ratio signals the strength of an auction. A higher ratio implies greater demand. As rate cut expectations and economic outlook evolves, so do the spreads across different maturities.
This paper provides US economic overview, resultant rate outlook, and divergence in auction demand across different maturities.
Contrasting spreads across maturities, the paper posits a hypothetical trade comprising of long 2Y and short 5Y spread. The spread benefits from continued yield curve inversion and from higher demand for 5Y treasuries.
Previously we highlighted a rebound in US treasury yields as market expectations of rate cuts were tempered. Rebound in CPI and jobs data pushed expectations further out.
Back in December 2023, FedWatch signalled up to six rate cuts of 25 basis points (bps) each. Cuts were anticipated to start in January 2024. Since then, two FOMC meetings have passed with rates unchanged. The CME FedWatch now signals just three cuts (of 25 bps each) starting in June 2024.
Source: CME FedWatch
Market expectations have shifted drastically even as Fed outlook remains unchanged. Fed’s dot plot from March FOMC meeting below shows that it anticipates three cuts this year. This is unchanged from the December dot plot.
Source: FOMC Projection Table
Shift in rate cut expectations resulted in treasury yields rebound. Since reaching its lowest in mid-Jan, 2Y yields have shot up by 42 basis points (nearly 10%) during Jan and early-Feb. Since then, 2Y yields have fluctuated but remain largely flat.
During this period, economic data has come in hotter than expected. CPI in Jan and Feb was above expectations. Non-Farm Payrolls (NFP) were substantially higher than expectations. Yields have ended up higher following the last two NFP and CPI prints.
GDP estimate in Jan was slower but following revisions, the release on 28/March showed GDP is also growing faster than expectations. PCE price index has come in close to expectations.
Against that backdrop, the two FOMC meetings thus far have resulted in (1) No hike & No guidance, and (2) No hike & Reaffirm guidance.
CONTRASTING AUCTION PERFORMANCE ACROSS MATURITIES
Demand for 10-Year Treasury Slowing : Auction for 10Y maturity was exceptional in February 2024. It was slower in March 2024. On 7/Feb, the US 10Y auction fetched a record USD 45 billion with a bid-to-cover ratio of 2.56.
The 12/March auction showed slowdown in demand. It fetched USD 39 billion with a lower bid-to-cover ratio of 2.51.
Bid-to-Cover ratio is the dollar amount of bids in a Treasury auction relative to the amount sold. The bid-to-cover ratio is an indicator of Treasury demand. High ratio indicates strong demand.
Robust Demand for 30-Year Treasury : Auction for the 30Y Treasury drew USD 27 billion during 8/Feb auctions. The March auction was lower at USD 22 billion but the Bid-to-Cover for 30Y treasuries was higher (2.47 in March vs 2.40 in Feb) indicating strong demand.
Demand for medium term treasuries (5Y and 2Y) is strongest : Demand for medium-term securities remains strongest. Last week, the 5Y Auction fetched a record USD 67 billion. 2Y notes fetched USD 66 billion (higher than any auction over the past year) while the 5Y notes fetched USD 67 billion.
Source: CME TreasuryWatch
Demand for medium-dated treasuries relative to the 10Y notes is visible in the bid-to-cover ratio. The ratio for 5Y and 7Y notes has risen since 22/Jan, while those for 10Y ones have softened.
Source: CME TreasuryWatch
Demand for medium term (1Y to 5Y) treasuries remains strong despite Fed offloading these from its balance sheet.
YIELD CURVE RE-INVERSION IS IN PLAY
Previously, we noted the trend of re-inversion in the yield curve. The 10Y-2Y inversion reached its deepest on 6/March. The 10Y-2Y spread performed worse than the 7Y-2Y and 5Y-2Y spreads.
Since then, the 7Y-2Y and 5Y-2Y spreads have underperformed the 10Y-2Y spread. The underperformance has been particularly pronounced since the FOMC meeting on 20/March.
Following that meeting, the 5Y-2Y and 7Y-2Y spreads did not recover as much as the 10Y-2Y spread.
This underperformance is likely to continue as demand for medium-dated treasuries (5Y and 7Y) remain sharply stronger than the demand for 10Y treasuries. Higher demand acts to push yields lower, leading to a wider spread with 2Y treasuries.
OUTLOOK FOR RATE CUTS REMAINS UNCERTAIN
Shaan Raithatha, senior economist at Vanguard, stated that his base case calls for no cuts in 2024.While FedWatch currently signals a rate cut at 12/June meeting, the probability is still far from firm.
Recent GDP figures suggest that the economy remains strong. It gives the Fed more room to keep rates elevated. During this period, the yield curve is likely to continue re-inverting.
HYPOTHETICAL TRADE SETUP
Auction dynamics for medium-dated treasuries signals upside for a spread comprising of long 2Y treasuries and short 5Y ones. Using CME’s Yield futures, investors can position across the yield curve intuitively.
Yield futures are quoted directly in yield with a 1 basis point change in the yield representing a P&L of USD 10. As yield futures across various maturities represent the same notional, spread P&L calculations are equally intuitive with a 1 basis point change in the spread between two separate maturities also adding up to a P&L of USD 10.
As demand for 5Y treasuries rise, yields on those will fall relative to 2Y notes. Yields on 5Y softening compared to 2Y notes will result in re-inversion of the 5Y-2Y spread. Against that backdrop, the following hypothetical trade set up will deliver a risk-reward ratio of 2.1x:
• Entry: 17.30 basis points
• Target: 46 basis points
• Stop Loss: 31 basis points
• Profit at Target: USD 287
• Loss at Stop: USD 137
• Reward to Risk: 2.1x
MARKET DATA
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