Last week was an absolutely massive one for US Treasury issuance and it produced some interesting auction results.
To wit, the below chart of indirect bidders’ participation in Tuesday’s 2-year auction, from Deutsche Bank.
Indirect bidders, a proxy for foreign central banks, were awarded 33 per cent of the new 2-year note, a significant drop compared with the circa 69 per cent awarded a month ago. What’s even more remarkable, however, is that that 33 per cent figure comes after the US changed the way it defines indirect bidders, a move which according to Deutsche boosts the figure by 15 to 20 per cent.
Thus the percentage awarded to indirect bidders in Tuesday’s 2-year auction may have been as little as 13 to 18 per cent under the old definition, and that would have been a record historical low, according to Deutsche.
Here’s the bank’s commentary:
To rationalize these results, we could first argue that this weakness may have been a mere reflection of the competition from the one year-bill auction held 90 minutes earlier, which saw strong customer participation (1.5bp through market, 68% awarded to indirect bidders and likely strong foreign participation). Moreover the strength of the bill auction may have pushed investors to buy a significant amount of 2Y paper ahead of the auction, taking the short base out of the market.
Another explanation though could be that Foreign Central Banks may have found only little value in the 2Y note despite the magnitude of the carry and roll down. Given signs of improvement in the economic outlook and recent comments from San Francisco Fed President Yellen suggesting that the Fed would be ready to tighten monetary policy adequately when the time comes, the likelihood of experiencing rate hikes between H2 2010 and H1 2011 has increased. In this context, the amount of risk premium embedded in the 1Y1Y vs. 1Y OIS spread has rebounded from low levels one week ago (see FIW 24-July-2009 for a discussion on the dangers of carry trades), and has more room to increase. Foreign Central banks may thus have favored 12M bills rather than 2Y notes in order to benefit from lower duration and marked to- market risk.
In this context, tension was palpable ahead of the $39bn 5Y auction on Wednesday. Given a return of risk aversion in the morning and a substantial decline in equity and commodity markets, the 5Y yield failed to embed a proper concession. The auction tailed a very large 5.4bp, the bidto- cover ratio fell to 1.92 from 2.58 in June, the lowest level since September 2008 . . . We have shown in the past that there had been an impressive level of correlation between the level of participation of indirect bidders and foreign central banks and the level of yields. In other words, we showed that indirect bidders would generally bid more aggressively during the auctions when Treasury yields would be cheap. With this auction, the relationship has broken down (see chart below), suggesting that Foreign Central Banks may not have perceived the level of 5Y yield as being cheap anymore in the context of improved economic outlook.
However, 10-year Treasuries did manage to stage a rally on Friday after a relatively successful 7-year auction the day before. In that particular auction, indirect bidders were awarded about 60 per cent of the sale, prompting much ‘relief‘ about central bank-buying in the market.
Regardless of foreigners’ absolute buying of US Treasuries then, what does seem to be happening is a concerted move from the front-end to the long-end of the curve — which in itself could result in an interesting bull-flattening development. If it lasts.
Related links:
Convexed - FT Alphaville
Smoke, mirrors and Treasury sales - FT Alphaville
Substitutability in Treasuries and Quantitative Easing - The Bond Tangent
