Insights 
VT 
The U.S. Treasury auctioned $70 billion in 5-year notes, achieving a high yield of 3.983%. At the time of the auction, the WI level was 3.975%, with a tail of +0.8 basis points compared to the 6-month average of -0.3 basis points.
The bid-to-cover ratio was 2.31x, lower than the 6-month average of 2.39x. Direct buyers accounted for 29.5%, above the 6-month average of 18.9%, while indirect buyers participated at 58.28%, below the 6-month average of 70.1%.
Dealer Participation
Dealers took 12.23%, slightly exceeding their 6-month average of 11.0%. Last week’s 20-year note auction saw international buyers at the 6-month average, unlike most recent auctions.
Domestic buyers have compensated for the reduced international participation, affecting the overall performance and demand of the auctions.
Based on the auction data from Michalowski, we believe the path of least resistance for interest rates is higher in the short term. The poor demand, evidenced by the positive tail and low bid-to-cover ratio, signals that the market is struggling to absorb the amount of debt being issued at current prices. This suggests bond prices are likely to fall, and yields will need to rise to attract buyers in subsequent auctions.
This is not an isolated incident, confirming our view of a broader trend. The U.S. Treasury’s auctions for $44 billion in 2-year notes and $28 billion in 7-year notes in late May 2024 also saw weak demand, both posting “tails” that indicated yields had to rise to sell all the debt. This pattern of sluggishness across different maturities reinforces the idea that the market is becoming saturated with U.S. debt.
Government Borrowing and Debt
We see the fundamental issue as the sheer scale of government borrowing. The Congressional Budget Office projects that federal debt held by the public will reach 99% of the nation’s GDP by the end of 2024 and will continue to climb. With such a massive supply pipeline, it is logical to expect that investors will demand better compensation, pushing yields higher.
Therefore, we are positioning for higher interest rates through derivative markets. This involves strategies like shorting 5-year and 10-year Treasury futures or buying put options on bond ETFs like IEF. The consistently weak auction metrics provide a strong signal that these bearish bond positions are warranted over the coming weeks.
The waning interest from foreign buyers, highlighted by the low Indirect bid, also has implications for the U.S. dollar. Less foreign demand for our bonds translates directly into less demand for dollars to purchase them. Historically, periods of souring foreign sentiment on U.S. debt have preceded dollar weakness, making positions that bet against the dollar an attractive secondary trade.
The ongoing uncertainty also suggests a rise in interest rate volatility. The CME FedWatch tool indicates markets are pricing in a Federal Reserve that will remain on hold, creating tension as weak economic data clashes with persistent inflation. This environment makes buying options that profit from a large move in rates, such as straddles on Treasury futures, a prudent strategy to hedge against a sharp market repricing.
