Digging Into Bond Demand Fears

After starting the day on a positive note, US stocks fell late in Thursday’s session to finish the day lower. According to pundits, the reversal hinged on one primary factor: Long bond yields, which move opposite their price, jumped after a 30-year Treasury bond auction attracted allegedly weak demand. This adds to fears from two earlier auctions last week, which pundits say hint that supply is overwhelming demand. The implication: Treasury yields are set to soar. But we don’t think this time is any different than all the other ones claiming Uncle Sam’s credit line is on a short leash. Rates’ rise—and the supposedly tepid auction demand—look like sentiment-driven wiggles. It is likely an error to extrapolate them.

Following Thursday’s auction, pundits pointed to two things: One, the gap between the lowest bid price (highest yield) and the median was the narrowest since late 2021—a sign to them of weak demand. Furthermore, like August’s 30-year auction, concern centered on primary dealers taking more than their usual share, implying investors were stepping back. In the wake of the auction, 10-year Treasury yields surged to 4.70% Thursday from 4.57% Wednesday, while 30-year yields leapt to 4.87% from 4.71%, seemingly confirming the “poor” auction results.^[i] Auction coverage pointed out that the lowest-bid-to-median spread was the worst since November 2021’s 30-year auction. That day, though, 30-year Treasury yields fell and, lo and behold, no one noticed. And that didn’t influence subsequent auctions.

A look at intra-day timing further quashes pundits’ narrative. The big move up in 30-year yields occurred before the 1:00 PM EDT auction, which seemed mostly motivated by 8:30 AM’s higher-than-expected headline CPI release. In light of the knee-jerk reaction to inflation fears, it isn’t surprising bidders were spooked and primary dealers had to sop up more bonds than usual. But that appears mostly tied to a one-off calendar event (the CPI release coinciding with the auction), not fundamentally weak demand. Following the auction, 30-year yields drifted and continued doing so into the next day. If there were a significant issue tied to the auction, yields should have kept rising. Heck, fundamentally, primary dealers are market makers in Treasury issuance—their role is to step in and mitigate volatility, if needed. The action last week is a feature of the system, not a bug. The trend would have to persist for quite a while to matter much. It didn’t in April 2010, when pundits argued primary dealers’ snapping up a large share indicated a looming US debt crisis.^[ii] We doubt now is different.

Some also suggest the Fed alone continues to prop up long bonds, even though it isn’t buying them at auction. Even as it lets T-bills (short-term, one-year maturity or less Treasurys) roll off its balance sheet—which some dub “quantitative tightening”—it has added $39.2 billion to its long-term Treasury holdings this year.^[iii] While huge sounding, this is a drop in the bucket when scaled properly. For perspective, long-term Treasurys’ average daily trading volume is $68 billion in the year through September.^[iv]

Consider the bigger demand picture: Thursday’s 30-year auction’s bid-to-cover ratio was 2.35 times oversubscribed.^[v] In other words, there was more than twice as much demand as Treasurys supplied. While that was down from last month’s 2.46, it matched March’s ratio (and was between April’s 2.36 and February’s 2.25).^[vi] The financial press also suggested the 10-year auction’s 2.50 bid-to-cover last week was “soft,” but monthly auctions from March through June were lower.^[vii]

All this is in line with Treasury auctions’ bid-to-cover ratios over the last two decades. Take the benchmark 10-year Treasury. Its last auction with a bid-to-cover ratio below 2.00 was March 2008’s 1.79.^[viii] Yields fell thereafter. In the 1990s and early-2000s, 10-year bid-to-cover ratios frequently fell below 2.00, without resulting interest rate spikes.

The lesson here: Don’t extrapolate one-day moves. Like stocks, bonds—and auction demand—can be volatile and driven by short-term sentiment swings. Now, yields are up from their springtime lows—and much more from their record lows in 2020. It is entirely possible they move higher in the short term, but we doubt it lasts—the recent upturn looks like a sentiment-based overreaction to Federal Reserve officials’ ever-mutating projections. Regardless, 10-year Treasury yields are still below their 5.6% average since 1954.^[ix] Yields’ moving back to where they have mostly been the last seven decades hardly strikes us as alarming. And there is little evidence stocks can’t rise or the economy grow with rates higher than the ultra-low yield 2008 – 2021 stretch.

Then consider Treasurys’ underlying drivers. Treasury auctions regularly see bids more than two times the amount on offer because, though unappreciated, America’s credit is rock solid. The US Treasury has no problem servicing its debts since its revenues dwarf interest payments several times over. Focus on the fundamentals. Long-term Treasury yields move most on inflation and inflation expectations—and inflation is moving lower alongside bond-market-implied inflation expectations. Anything can happen short term—like sentiment-driven yield spikes—but with inflation trending down, long bond yields likely follow longer term.

Hat tip: Senior Fixed Income Research Analyst Mike Weston.