Where does the long-short game of U.S. Treasury bonds originate?

At the end of the year, there is a tug-of-war situation in the U.S. Treasury market. On one hand, the carry trade caused by the interest rate differential has led to overseas funds continuing to buy U.S. Treasuries.

From the perspective of the euro, the interest rate differential between the 10-year U.S. Treasury and the 1-year Euribor has widened since the beginning of 2024, reaching 2.096% by the end of 2024. From the perspective of the yen, although the interest rate differential relative to the dollar has narrowed, considering the recent trend of yen depreciation, investing in dollars remains the dominant trade. Therefore, based on the above, we believe that multinational funds, especially those from the eurozone and yen zone, have become an important purchasing power for U.S. Treasuries.

On the flip side, the U.S. Treasury market is currently facing significant short-selling pressure. On December 26, 2024, the 10-year U.S. Treasury yield briefly broke 4.6%, reaching a new high since May 2024. We believe that the rebound in U.S. Treasury yields is mainly driven by two factors: tightening liquidity in the U.S. market at year-end and the uncertainty surrounding the interest rate cut path and inflation trends in 2025.

The temporary tightening of liquidity at year-end has become the main driving factor for the U.S. Treasury yield to break 4.6%. On December 26, 2024, the SOFR rate rose to 4.53% after the Federal Reserve's rate cut in December, a rare occurrence; on December 31, 2024, the SOFR rate remained at a high level.

This reflects that the pressure in the financing market has intensified at year-end, making dollar financing more difficult. Commercial institutions typically reduce activities to enhance the robustness of their balance sheets in order to meet regulatory requirements. In addition, the scale of the Federal Reserve's reverse repurchase operations reached a high level at year-end, absorbing some liquidity from the U.S. Treasury market.

The uncertainty regarding the interest rate cut path and inflation expectations in 2025 is also an important reason for the recent rise in the 10-year U.S. Treasury yield. Currently, the market has a hawkish expectation for the Federal Reserve's interest rate cuts, with only a possible cut of around 50 basis points in 2025, and the long-end U.S. Treasury market has clearly "priced in" this relatively aggressive expectation quickly.

At the same time, the confusion regarding future interest rate cut paths and inflation expectations has led to a significant increase in demand for short-end U.S. Treasuries, causing the U.S. Treasury yield curve not only to end the "inversion" but also to show a significant widening of the term spread. Although the long-end U.S. Treasury yields have risen recently, we believe that liquidity is a short-term issue, and the market's speculative short-selling behavior has not significantly increased. The current high-yield long-end U.S. Treasuries have strong allocation value.

At the end of the year, there is a tug-of-war situation in the U.S. Treasury market. On one hand, the carry trade caused by the interest rate differential has led to overseas funds continuing to buy U.S. Treasuries. The Federal Reserve has already released clear signals at the December 2024 meeting that it is unlikely to cut rates in January 2025, and the pace of rate cuts for the entire year will slow down On the other hand, the European Central Bank also announced a 25 basis point rate cut in December last year, and the Bank of Japan paused its rate hike in December last year. Although the uncertainty surrounding the Federal Reserve's rate cuts is rising, considering the follow-up of global central banks' interest rate policies, we believe that the interest rate differential of the US dollar relative to other currencies will still be maintained, and the carry trade makes US Treasuries still highly attractive to global funds. Over the past year, foreign investors have shown an accelerating trend in their holdings of US Treasuries.

As of the end of October 2024, foreign investors held a total of USD 8.6 trillion in US Treasuries. From January to October 2024, foreign investors added USD 650 billion in US Treasuries. If we refer to the interest rate differential between the 10-year US Treasury and the 1-year Euribor, it has shown an upward trend since the beginning of 2024, reaching 2.096% by the end of 2024.

The Japanese yen, as a funding currency for carry trades, has seen a narrowing interest rate differential relative to the US dollar; however, considering the recent trend of yen depreciation, investing in US dollars remains the dominant trade. Therefore, based on the above, we believe that cross-border funds, especially those from the Eurozone and yen zone, have become an important purchasing power for US Treasuries.

On the flip side, the US Treasury market is currently facing significant short-selling pressure. On December 26, 2024, the yield on the 10-year US Treasury briefly surpassed 4.6%, reaching a new high since May 2024. We believe that this rebound in US Treasury yields is mainly driven by two factors: the tightening of liquidity in the US market at year-end and the uncertainty regarding the rate cut path and inflation trends in 2025.

First, the rapid upward pressure on the 10-year US Treasury is not driven by large-scale sell-offs by active institutional traders such as hedge funds under speculative trading. The short positions of hedge funds in 10-year US Treasuries have not increased and have even shown a certain degree of decline, confirming this point.

Secondly, the MOVE index, which reflects the volatility of US Treasury futures, has not shown a significant increase, indicating that the market's perception of volatility in the US Treasury market remains within a normal range, and large-scale speculative short-selling activities have not significantly increased. Overall trading expectations for US Treasuries remain relatively stable.

The temporary tightening of liquidity at year-end has become the main driving factor for the US Treasury yield to break through 4.6%. We observed that on December 26, 2024, the SOFR rate rose to 4.53% after the Federal Reserve's rate cut in December, which is rare, and the spread with the lower limit of the Federal Reserve's interest rate corridor, the Overnight Reverse Repurchase Agreement (ON RRP), has significantly widened As of December 31, 2024, the SOFR rate remains at a high level.

This reflects the intensified pressure in the financing market at the end of the year, where commercial institutions typically reduce activities to enhance the robustness of their balance sheets in order to meet regulatory requirements, while commercial banks and their primary dealer subsidiaries show a declining willingness to expand assets through money market funds. This contraction forces market participants to either seek alternative financing channels or bear higher financing costs.

In this context, some commercial institutions may face pressure to liquidate part of their assets to meet liquidity needs, including selling some U.S. Treasury assets for liquidity. The increase in commercial short-selling contracts for 10-year U.S. Treasuries is a testament to this phenomenon, as this indicator reflects the situation of commercial institutions selling U.S. Treasuries to meet liquidity demands.

Synchronously rising with the SOFR rate is the scale of ON RRP, which, similar to previous year-ends, rose to a high of $473.5 billion on the last day, also absorbing some liquidity from the U.S. Treasury market to a certain extent. However, the current EFFR-IORB spread, which measures liquidity pressure in the banking system, remains low, with the effective federal funds rate (EFFR) consistently at 4.33% and no significant upward pressure.

This indicates that the overall liquidity situation of banks remains robust. As the quarter-end effect diminishes, we expect money market funding rates to enter a low-volatility state again.

The uncertainty regarding the interest rate cut path in 2025 and inflation expectations is the essential reason for the rise and high-level fluctuations in U.S. Treasury yields, which also leads to the steepening of the yield curve.

As mentioned in our 2025 U.S. Treasury outlook report, the Federal Reserve's interest rate cut path will remain the dominant factor for long-term U.S. Treasuries, and whether long-term U.S. Treasury yields can decline hinges on medium- to long-term inflation expectations, while the steepening of the yield curve is highly probable. Currently, the market's expectations for the Federal Reserve's interest rate cuts are relatively hawkish, with only a possible cut of around 50 basis points in 2025, and the long-term U.S. Treasury market has clearly "priced in" this relatively aggressive expectation.

At the same time, the confusion regarding future interest rate cut paths and inflation expectations has led to a significant increase in demand for short-term U.S. Treasuries, as the U.S. Treasury yield curve not only ended its "inversion" but also showed a significant widening of the term spread.

We believe that the steepening of the yield curve is essentially due to the market's understanding of the short-term interest rate cut path and inflation in the U.S., but for the long term, there is higher uncertainty regarding inflation expectations, interest rate environment, fiscal sustainability, and economic growth, leading to a significant rise in term premiums.

On another level, the end of the inversion in U.S. Treasury rates also reflects, to some extent, the market's improved expectations for the U.S. economy and an increase in market risk appetite The holding value of long-term U.S. Treasuries is highlighted at present. We reiterate the importance of capturing the allocation and trading value under the range fluctuations of long-term U.S. Treasuries, while also pointing out potential trading opportunities for a steepening yield curve. Although long-term U.S. Treasury yields have risen significantly recently, we believe that liquidity is a short-term issue, and market speculative short-selling behavior has not increased significantly. The current high yields of long-term U.S. Treasuries possess strong allocation value.

Authors of this article: Zhan Chunli, Zhang Xiaozijiao, Source: Guotai Junan Overseas Macro Research, Original Title: “【Guotai Junan International FICC Strategy】Where Does the Long and Short Game of U.S. Treasuries Come From?”

Risk Warning and Disclaimer

The market has risks, and investment requires caution. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial conditions, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Investment based on this is at one's own risk