Bond merchants on a rocky highway are filled with auctions

The Treasury Department building in Washington, DC, USA on Saturday, November 20, 2021. The Treasury Department's chief climate adviser said he expected the country's financial regulators to take "very strong and systemic" measures over the next year be to strengthen the resilience of financial institutions to the risks of climate change. Photographer: Samuel Corum / Bloomberg

Samuel Corum / Bloomberg

No one would choose to sell bonds under these conditions – which could lead to a rocky, shortened week in the US Treasury market.

To complete the monthly cycle of two-, five-, and seven-year banknotes before the holidays on Thursday, the Treasury is cramming them on Monday and Tuesday, which has not gone well in the past. To make matters worse, the White House announced the nomination for the chairman of the Federal Reserve until Thanksgiving in addition to the dozen publications on the economic situation on Wednesday.

Meanwhile, the exceptional volatility, particularly in short-term yields, last month got a second wind on Friday amid looming European pandemic lockdowns. The yield on the two-year bond fell at times by up to 5.8 basis points as the government bond markets around the world priced in the possibility of a further economic slowdown, which could prevent central banks from increasing interest rates. US traders have scaled back Fed rate hike expectations, postponing the hike from July next year to September and pricing in two rate hikes by the end of 2022.

The moves were subsequently reversed following comments from Fed officials Richard Clarida and Christopher Waller about the potential for a faster reduction in security purchases. Still, there have been nine daily changes of more than three basis points since October 15, compared with just five this year to date. The wild price action unfolded, pushing the ICE BofA MOVE index of expected volatility to its highest level since March 2020 – when consumer price inflation rose to levels that challenged the central bank's tentative plan to reduce and reverse its asset purchases by mid-2022 not to raise interest earlier.

Reduced liquidity with continued heightened volatility and uncertainty about the political course could certainly have an impact on the reception of upcoming treasury auctions, even if the market will absorb less nominal supply after supply cuts, said Credit Suisse strategist Jonathan Cohn. "Aside from the auctions, it will be particularly worth seeing how the market digests it over the holidays and the end of the month."

Since 2012, when the Treasury auction cycle coincided with Thanksgiving week, a relatively rare occurrence, the seven-year sector fell an average of six basis points in the first week of December, Cohn said. In the other years it has rallied an average of 4 basis points.

At the same time, market participants are waiting for US President Joe Biden to announce his election for the Fed chairmanship. A decision to nominate Lael Brainard for a second term in place of Jerome Powell could quickly re-price short-term US interest rates – and turn auction calculations on its head, even if the shock wears off relatively quickly.

"Markets will have some kind of knee-jerk reaction to chair selection, but once that clears there won't be a big shift in the outlook for the next few quarters," said Victoria Fernandez, chief market strategist at Crossmark Global Investments.

To make matters worse, the quarterly process of swapping expiring Treasury futures for new ones will be intensified in the coming week and the erosion of liquidity on the cash market has made the two-year “calendar role” particularly risky.

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