Short-term real Treasury yields are near zero due to recent increase in inflation expectations
3-year T-note auction to yield near 1.52%
JOLTS U.S. job openings expected to remain generally strong
Short-term real Treasury yields are near zero due to recent increase in inflation expectations — U.S. inflation expectations have recently risen mainly because of the 17% recovery in Sep WTI crude oil prices seen in the past 1-1/2 months. The sharp rally in crude oil prices has been instrumental in pushing inflation expectations higher since oil prices and inflation expectations generally show a fairly strong correlation.
The rally in crude oil prices has helped push the 10-year breakeven inflation expectations rate up by +14 bp to the current level of 1.81% from the 10-month low of 1.67% posted in mid-June. Meanwhile, the 5-year 5-year-forward breakeven rate since mid-June has risen by a larger +20 bp to current level of 2.00%. The 5-year 5-year forward breakeven rate measures 10-year inflation expectations by looking at the 5-10 year horizon and thereby eliminating shorter-term factors that are expected to impact inflation over the next 5 years.
The recent rise in inflation expectations in turn has been a significant factor in pushing Treasury yields higher. For example, over the same time-frame that the 10-year inflation breakeven rate has risen by +14 bp since mid-June, the 10-year T-note yield has risen by +9 bp to 2.26%
On the shorter-end of the Treasury curve, the recent rise in inflation expectations means that inflation-adjusted yields are near zero. For example, the current 3-year benchmark T-note yield of 1.50% exactly matches the 3-year breakeven rate of 1.50%, meaning the real yield on the 3-year is zero. That means that buyers of today’s 3-year T-note auction can expect to earn nothing on an inflation-adjusted basis over the course of their investment, if actual inflation turns out to match the current expected inflation rate. Meanwhile, the 2-year T-note yield of 1.35% currently carries an inflation-adjusted yield of 0.03% against the current 2-year breakeven rate of 1.32%.
The current situation is at least a mild improvement from the last nine years when T-notes with maturities of 5 years and shorter traded mostly below inflation expectations, meaning investors could expect to lose money on their T-note purchase on an inflation-adjusted basis.
Short-term T-note yields continue to trade at unattractive levels relative to inflation expectations mainly because the Fed is still pegging short-term interest rates at abnormally low levels. The Fed has the federal funds target pegged at the extremely low mid-point target level of 1.13%, which represents a negative inflation-adjusted rate of -0.67% relative to 10-year inflation expectations of 1.80%. In addition, investment demand remains strong for shorter-term Treasury securities, despite poor returns, because of continued flight-to-quality fall-out from the global financial crisis.
Treasury yields in our view will continue to move slowly higher in coming years and eventually produce more normal inflation-adjusted yields, assuming that the U.S. economy continues to expand and the Fed continues to normalize monetary policy by pushing up the federal funds rate. Investors will not lend out their money forever for virtually no inflation-adjusted return. However, this rise in Treasury yields to more normal inflation-adjusted levels will likely take at least several more years considering that inflation is lagging and U.S. economic growth remains tepid.
3-year T-note auction to yield near 1.52% — The Treasury today will sell $24 billion of 3-year T-notes. The Treasury will then continue this week’s $62 billion coupon package by selling $23 billion of 10-year T-notes on Wednesday and $15 billion of 30-year T-bonds on Thursday. This week’s 10-year and 30-year auctions will be of new securities as opposed to reopenings of existing securities.
Today’s new 3-year T-note issue was trading at 1.52% in when-issued trading late Monday afternoon. That translates to an inflation-adjusted yield of 0.02% against the current 3-year breakeven rate of 1.50%. The 12-auction averages for the 3-year are as follows: 2.81 bid cover ratio, $52 million in non-competitive bids, 4.5 bp tail to the median yield, 15.6 bp tail to the low yield, and 51% taken at the high yield.
The 3-year is the second least popular coupon security behind the 2-year T-note among foreign investors and central banks. Indirect bidders, a proxy for foreign buyers, have taken an average of only 52.6% of the last twelve 3-year T-note auctions, which is well below the average of 60.6% for all recent Treasury coupon auctions.
JOLTS U.S. job openings expected to remain generally strong — The market consensus is for today’s June JOLTS U.S. job openings report to show a +34,000 increase to 5.700 million, stabilizing after May’s -301,000 plunge to 5.666 million. Despite May’s large -301,000 decline, the series is only slightly below the 12-month trend average of 5.679 million, indicating that jobs offerings are still relatively plentiful. The continued high level of the JOLTS job openings series is a positive leading indicator for the payroll report since many job openings will turn into an actual job hire within 1-3 months when the hiring process is complete.
On the job hiring front, the markets were encouraged by last Friday’s payroll report of +209,000, which was stronger than market expectations of +180,000. Payroll growth on a year-to-date basis is solid at +184,000, indicating that U.S. businesses continue to hire new employees at a firm clip.