The hawkish stance of the Federal Reserve withstands the test: the yield on 2-year US Treasury bonds exceeds 5% for the first time since 2006, while demand remains strong.

Last week, after Federal Reserve Chairman Powell revealed his readiness to further raise interest rates, the hawkish stance of the Federal Reserve faced its first test - the sale of two-year US Treasury bonds.

On Monday, August 28, US Eastern Time, the US Department of the Treasury announced the completion of a $45 billion sale of two-year US Treasury bonds. Although the results were not entirely consistent, overall demand was strong, and the Fed's stance passed the test.

The winning bid rate for this sale was 5.024%, the first time since July 2006 that the bid rate for a sale exceeded 5%. It was about 20 basis points higher than the previous sale rate of 4.823% in July, but still lower than the pre-issuance rate of 5.028%.

Among the last four sales, this was the third time that the so-called tail, where the stop-out rate is higher than the pre-issuance rate, did not occur. This is a positive signal. If a tail occurs, the larger the tail, the lower the bid price that the Treasury Department is forced to sell to bidders.

Commentators have pointed out that the record high winning bid rate for this sale reflects the intensified selling pressure in the US Treasury market last week, as investors expect another interest rate hike by the Federal Reserve later this year. In early July, the yield on two-year US Treasury bonds in the secondary market reached its highest level since 2007, but the sale rate for two-year Treasury bonds at the end of July fell, and the sale results did not reflect the peak interest rates in the secondary market.

The Chicago Mercantile Exchange's (CME) Federal Reserve observation tool shows that on Monday, during intraday trading, the probability of the Federal Reserve keeping rates unchanged at its September meeting slightly exceeded 80%. The probability of a 25 basis point rate hike in November slightly exceeded 58%, compared to less than 43% a week ago.

In this sale, the total bid value from investors exceeded $108 billion, resulting in a bid-to-cover ratio of 2.943, the second-highest level since April 2020, second only to the 2.944 ratio in the January sale. This far exceeded the previous ratio of 2.78 in July and the recent average ratio of 2.71, reflecting strong demand.

The distribution of winning bids in this sale indicates robust demand. Indirect buyers, including foreign central banks and other official institutions, as well as private investors, accounted for 65.01%, lower than the previous sale's share of 65.45%, but higher than the recent six-sale average of 63.03%.

Direct buyers, including the Federal Reserve and other US federal government entities, accounted for 20.0%. Primary dealers, who absorbed the unsold portion of bonds and avoided a failed auction, accounted for 14.98%, reaching a new high since May.

The sale of two-year US Treasury bonds can be described as strong overall, boosting market sentiment.

After the sale results were announced, prices of US government bonds in the secondary market partially rebounded. The yield on benchmark 10-year US Treasury bonds briefly fell below 4.21% during early trading, approaching the intraday low of 4.20% and moving away from the high of 4.36% reached last Tuesday, the highest level since November 2007. Subsequently, it rose back to 4.21%.

The yield on 2-year US Treasury bonds, which is more sensitive to interest rates, further declined, dropping below 5.06% during midday trading in the US stock market. On Monday, during European stock market hours, the yield briefly rose above 5.10%, reaching the highest level since July 6 and approaching the mid-year high of 2007 set on July 6.