Bond Traders See Curve Steepening as Just a Pause
(Bloomberg) -- The Treasury market is about to absorb $119 billion of note auctions, all maturing in seven years or less. That means last week’s rare bout of yield-curve steepening may just be the pause that refreshes.
The spread between 2- and 10-year yields widened last week for the first time since June after U.S. President Donald Trump expressed his displeasure with the Federal Reserve’s rate increases, and Friday’s bear steepening was supported as reports that the Bank of Japan may debate policy changes put pressure on Japanese government bond futures. Before Trump’s remarks, the curve was marching toward inversion, flattening to its narrowest level since 2007 after Fed Chairman Jerome Powell reiterated the central bank’s commitment to gradually tighten policy.
The days ahead may reignite flattening bets as traders digest 2-, 5- and 7-year auctions, including floating-rate securities. The fixed-rate portion will raise the most new cash since 2013. The U.S. is also expected to report that gross domestic product grew at a 4.3 percent annualized clip last quarter, its strongest pace since 2014. While that’s before trade tension kicked into high gear, it may still reaffirm the economic backdrop for Powell’s plan to hike rates.
“Any in-range steepening is an opportunity to scale back into flatteners,” said Ian Lyngen, a rates strategist at BMO Capital Markets. “It’s difficult to fade the flattener given the Fed’s commitment to normalize rates in spite of relatively low core inflation and the potential economic headwinds from the trade war.”
The Treasury is selling $35 billion of two-year notes, $18 billion of two-year floating-rate notes, $36 billion of five-year debt and $30 billion of seven-year securities. The fixed-rate two-year is $1 billion larger than last month’s, part of the department’s move to boost sale sizes as it plugs swelling deficits and makes up for the Fed’s shrinking balance sheet.
The Treasury has leaned toward shorter maturities as it increases issuance, contributing to the yield curve’s collapse. At about 30 basis points, the 2- to 10-year spread is down from almost 100 basis points a year ago.
On Aug. 1, the Treasury will unveil its latest borrowing plans. Wells Fargo Securities strategists estimate Treasury will increase the two- and three-year auctions by $1 billion per month, and implement a one-time increase of $1 billion for floating-rate notes as well as the five- through 30-year tenors. The pattern of increases would resemble Treasury’s announcement in May.
“It’s not the type of issuance schedule that would get us worried about pressure toward higher yields further out the curve,” Lyngen said.
Another date to keep an eye on is July 31, when the Bank of Japan releases its next decision. Any changes from officials, who are looking for ways to keep their stimulus program sustainable while reducing the harm it causes, could have a knock-on effect in the U.S. market.
The shape of the curve is drawing scrutiny because inversion has typically preceded U.S. recessions.
Last week, St. Louis Fed President James Bullard said that if long-term yields remain near present levels and the FOMC raises rates at the pace it forecast in June, the curve would invert in late 2018. He also said Trump’s comments wouldn’t affect policy makers.
The Fed has raised rates twice this year and projects two more increases in 2018. Overnight index swaps are pricing in around 1.5 additional increases for this year.
Powell “sees a clear reason to continue rate hikes as well as balance-sheet reduction, so we don’t think there’s anything that will give him pause at the moment,” said Mona Mahajan, U.S. investment strategist at Allianz Global Investors. She also sees inversion possible by year-end if the Fed sticks to its path.
With those expectations entrenched in the market, the effect of Trump’s remarks could dim.
“The knee-jerk reaction to Trump’s foray into monetary policy will fade rather quickly,” said BMO’s Lyngen. “The Fed will change policy when the economic reality suggests it’s time.”
What to Watch This Week
- The U.S. Trade Representative will hold a hearing on tariffs for $16 billion in Chinese products on July 24, while the House of Representatives has a hearing on steel tariff exclusions
- The main event for U.S. economic data is the first print of second-quarter GDP
- July 23: Chicago Fed; existing home sales
- July 24: FHFA home price index; Markit PMI; Richmond Fed
- July 25: MBA mortgage applications; new home sales
- July 26: Trade balance; wholesale inventories; jobless claims; durable goods; Bloomberg consumer comfort; Kansas City Fed
- July 27: Second-quarter GDP; University of Michigan sentiment
- Here’s the schedule for Treasury auctions
- July 23: $51 billion of three-month bills; $45 billion of six-month bills
- July 24: Four-week bills; $35 billion of two-year notes
- July 25: $18 billion of two-year floating-rate notes; $36 billion of five-year notes
- July 26: $30 billion of seven-year notes
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