Interest in US Treasuries Renewed, Fueled by Market Bets on Fed Rate Cuts

The $67 billion worth of 5-year Treasury notes auction garnered a yield of 4.235%, which was lower than the government's prior auction offer of 4.320% and the six-auction average of 4.359%. Overseas investors were assigned more than 70% of the bonds, marking a new high for the year, while primary dealers were only allotted 12.7% - the lowest since November 2023 -indicating robust demand for the belly of the yield curve. In addition, the dip in US March Conference Board consumer confidence to 104.7, a four-month low and below economists' forecast of 106.8, suggests the optimistic sentiment surrounding the US economy is weakening. Following the results, the yields for different maturities of US Treasuries experienced varying degrees of decline.

As a barometer of demand for US Treasuries, recent demand from US commercial banks has caught the market's attention. Weekly holdings data compiled by the Federal Reserve showed that commercial banks bought $103 billion of Treasuries and non-mortgage debt from federal agencies in the two-week period ended March 13. According to statistics from RBC Capital Markets, this marks the largest percentage increase over a two-week period since June 2020, when market concerns were fueled by the pandemic.

Some analysts have connected the recent bank demand with the dovish comments from the Federal Reserve. Although the market is generally worried that the Fed may cut interest rate projections from three to two at the March meeting, the Fed still insists on cutting interest rates three times this year after raising economic growth and inflation expectations. Powell's interpretation of some data is also intriguing. He acknowledged that recent inflation data has been high, but he said that early-year data is heavily affected by seasonal factors and inflation is still on a slow downward trend. After the March meeting, market expectations for interest rate cuts began to reignite. According to data from the CME FedWatch Tool, futures traders now expect a 70.1% chance of a 25 basis point rate cut by June, up from less than 60% before the meeting.

More importantly, the Fed's comments support slowing down the pace of central bank balance sheet reduction. Although Fed officials this week are divided on timing of interest rate cuts, the time for reducing QT seems to be more certain than the time for the first interest rate cut. The expectation of the Fed, the major buyer of US Treasuries, returning is expected to further support demand for US Treasuries.

Blake Gwinn, head of US interest-rate strategy at RBC Capital Markets, said:" With deposit balances still elevated, loan growth slowing, and an approaching Fed cutting cycle, it makes sense for banks to begin adding higher yielding US Treasuries to asset portfolios".

On Tuesday, the Federal Reserve released its audited 2023 financial statement which showed a record-high annual loss of $114.3 billion, compared to a net profit of $58.8 billion in 2022. On the asset side, the Fed faced continued unrealized losses in securities holdings including US Treasuries and MBS due to the high interest rate environment. On the liability side, the Fed's interest expenses including the interest paid on reserve balances held by depository institutions at the Fed, as well as interest paid on reverse repurchase agreements with eligible counterparties, are more sensitive to interest rates. Under aggressive rate hikes, the Fed's total interest expenses in 2023 reached $281.1 billion, 2.75 times higher than the expenses in 2022.

Although the Fed's losses are just book losses and do not affect its operations, they will exacerbate the already large US government budget deficit. According to regulations, the Fed needs to transfer its income from securities investments to the Treasury Department after paying for its daily operating expenses to help the latter offset the federal deficit. The Fed's losses mean that its payments to the Treasury will be suspended, increasing pressure on the budget deficit.

The latest February personal consumption expenditure (PCE) inflation data will be released on Friday, and the market will closely watch this data.