Long-term rebound in Treasury futures on debt ceiling deal

(Bloomberg) – Treasury futures, which are linked to the 10-30 year portion of the U.S. Treasury bond market, rallied on thin volume on Monday as traders waited for a number of supportive factors to come into play, when trading resumes next Tuesday Memorial Day holiday.

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These include mounting expectations that the Federal Reserve is likely to raise rates again in June or July, and projections that passage of debt ceiling legislation will trigger a spate of short-term Treasury bill issuance that will drain markets of liquidity and potentially disrupt the Performance of Risky Assets. Also, this week brings a month-end rebalancing of the US Treasury Index to include large quarterly new issuance of 10- and 30-year debt, which could boost demand in these sectors of the market.

Government bond yields across the maturity spectrum hit their highest levels since early-mid-March on Friday, erasing most of the declines sparked by this month's regional bank failures, raising the specter of tighter lending standards across the board. The 10-year interest rate topped 3.85%, hitting a yearly low of under 3.25% in April. Yield increases in recent weeks, however, have been driven by shorter maturities, reflecting heightened expectations of Fed rate hikes.

The debt ceiling agreement could boost demand for long-dated government bonds as it is expected to prove restrictive on the economy, said Andrew Brenner, head of international fixed income at NatAlliance Securities.

“It's going to take money out of the economy at the federal level,” he said. But yield levels hit on Friday are also indicative of short bond positioning, which is causing buyers to be drawn into rallies, he said.

Price action in Treasury futures indicated that long-term government bond yields will fall when bond trading resumes on Tuesday, while short-term government bond yields remain near multi-month highs. The longest-dated Treasury contract, the Ultra Bond, was up 1 basis point as of 1:00 p.m. New York time than electronic trading on the CME Group Inc. platform through 6:00 p.m., the start of the trading day. went on a break in Asia. Volume was around 56,000 contracts, compared to a daily average of 254,000 this year through April.

While Congressional approval of the compromise reached by US President Joe Biden and House Speaker Kevin McCarthy remains uncertain, gains should be particularly pronounced in Treasury bonds, which have faced the greatest risk of not making payments to holders on time. These include government bonds maturing in the first half of June, which in some cases have yielded more than 7% last week as some investors chose to avoid them altogether. However, those yields started falling again on Friday as there were signs that a deal was within reach.

The agreement to suspend the debt ceiling until January 2025 could also prompt a repricing of US Treasury credit default swaps, derivatives that allow investors to hedge against defaults that have surged to multi-year highs over the past month. Fitch Ratings warned on May 24 that the US credit rating could be downgraded, putting the country on a negative watch as the debt limit was not reached until the federal government was nearing the end of its cash balance.

With Friday's swap agreements pricing in more than half of a quarter-point rate hike by the Fed in June and one fully priced in by July, the payrolls data due this week are crucial. Job creation exceeded economists' median estimate in April and each of the previous 12 months. In their public comments, however, Fed officials were divided on how to balance a anti-inflationary stance with the possibility that the central bank's ten rate hikes over the past 14 months, totaling five percentage points, warrant a pause in June .

“The inflation numbers aren't cool enough for the Fed,” Kevin Flanagan, head of fixed income strategy at Wisdom Tree Investments, said on Friday. “The market has already adjusted to a more hawkish Fed and time is running out until the June meeting.”

– With support from Benjamin Purvis, Liz Capo McCormick and Michael Mackenzie.

(Adds chart, futures price change and volume.)

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