Concerns about U.S. debt and deficits have been weighing on investors for some time, particularly as Treasury yields have moved higher. One way to gauge the health of the U.S. bond market is to watch Treasury auctions and, specifically, the level of investor demand for newly issued government debt.
Last week offered an encouraging signal.
Strong Demand for Treasury Debt
The Treasury issued nearly $40 billion in 10-year notes, with the auction producing a bid-to-cover ratio of 2.71. That means investors submitted $2.71 in bids for every dollar of debt offered.
That was well above the 2.52 average for similar auctions and represented the strongest reading since 2017.
The details beneath the headline were encouraging as well. Direct and indirect bidders, the two primary groups of investors participating in Treasury auctions, purchased almost 96% of the supply. Dealers, who generally absorb what other investors do not purchase, took just 4.3%, the lowest amount in a year.
Concerns surrounding U.S. debt and deficits aren't going away. And yields could certainly move higher. The 10-year Treasury touched 5% earlier this morning for the first time since 2023. But last week's auction provided an important reminder: at today's yields, there remains plenty of demand for U.S. Treasury debt.
Inflation Pressure Returns
The other major development last week was the latest inflation data for August, which suggested that some of the recent progress on inflation may have been temporary.
Energy prices have risen over the past several weeks as hostilities in the Middle East have increased. More importantly, however, inflation pressure isn't confined to energy. Nearly half of the components that make up the Consumer Price Index are now up 3% or more over the past year.
That sets the stage for this week's Federal Reserve meeting.
A Test for the Fed
Following the latest inflation report, markets are pricing in roughly an 85% probability that the Fed will raise interest rates. Given the latest inflation data, the case for leaving rates unchanged has become increasingly difficult to make.
That puts Fed Chairman Kevin Warsh in an interesting position.
Warsh has emphasized the Fed's commitment to controlling inflation. If policymakers leave rates unchanged, markets could begin questioning that commitment. If the Fed raises rates, however, Warsh could face renewed pressure from President Trump, who has recently returned to publicly calling for lower interest rates.
For investors, the significance of this week's meeting goes beyond whether the federal funds rate moves by 25 basis points.
The larger issue is the Federal Reserve's credibility and independence. Financial markets, and the bond market in particular, need confidence that monetary policy decisions are being driven by economic data and the Fed's inflation mandate rather than political pressure.
That's what we'll be watching most closely this week: what the Fed decides on Wednesday and, perhaps just as importantly, how Chairman Warsh and the White House respond afterward.
Often quoted in major national media, Adam is a Chartered Financial Analyst (CFA®), a CERTIFIED FINANCIAL PLANNER™ (CFP®), and has been included on the Forbes NextGen Best-in-State Wealth Advisors 2019 list. He is a member of the CFA Society of Los Angeles and the CFA Institute. Adam helps establish asset allocation strategy as a member of the EP Wealth Investment Committee, which supports all EP Wealth Advisors and their clients. The Committee’s top-down approach to portfolio construction begins with an outlook on the economy’s likely direction, followed by the implications for different economic sectors and asset classes. This culminates in strategic selection of the individual stocks, bonds, mutual funds or other investments deemed most appropriate for each individual client’s portfolio.
EP Wealth Advisors offers a comprehensive range of services to help you invest with greater insight, as well as develop a holistic wealth management strategy. To discuss your finances and investment goals, we invite you to contact one of our advisors.
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Video Transcript:
Adam Phillips:
Hi, everyone, and welcome back to The Market Update.
I was on the road the last couple of weeks visiting with clients, and one topic that came up quite a bit was the debt and deficit situation here in the U.S.
That’s obviously been a concern for investors for some time now. But with Treasury yields moving higher recently, I had a number of people ask a more specific question: What are we watching to gauge the health of the U.S. bond market?
And one of the things I mentioned was Treasury auctions.
When the government issues new debt, we pay close attention to how much demand there is from investors relative to the amount of debt being offered. One way we measure that is something called the bid-to-cover ratio.
And last week, we got a pretty encouraging data point.
The Treasury issued nearly $40 billion in 10-year notes, and the bid-to-cover ratio came in at 2.71. In other words, for every dollar of debt the Treasury was looking to sell, there were $2.71 worth of bids.
That’s well above the 2.52 average for similar auctions and, in fact, was the strongest reading we’ve seen since 2017.
There was another encouraging detail underneath the surface.
Direct and indirect bidders—the two main groups of investors that typically participate in these auctions—bought almost 96% of the supply. Dealers, who generally step in and absorb whatever is left over, took down just 4.3%. That was the lowest amount in a year.
So, despite all of the concern surrounding our debt and deficits—and those concerns certainly aren’t going away—the message from last week’s auction was pretty clear: there is still plenty of demand for U.S. Treasury debt at these yields.
Could yields move higher from here? Absolutely. Earlier this morning, the 10-year Treasury touched 5% for the first time since 2023.
But investors showed us last week that there are plenty of buyers who find today’s yields pretty attractive.
Now, the other big piece of news last week was inflation.
We received the latest inflation data for August, and unfortunately it suggested that some of the recent progress we’d made on inflation was only temporary.
Most of us have become painfully aware that energy prices have moved higher over the past several weeks as hostilities in the Middle East have picked back up.
But I think the more important point is that the inflation pressure isn’t limited to energy.
Nearly half of the components that make up the Consumer Price Index are now up 3% or more over the past year.
And that brings us to the big event this week: the Federal Reserve meeting on Tuesday and Wednesday.
Following the latest inflation report, markets are now pricing in about an 85% chance that the Fed raises interest rates.
And frankly, given the latest inflation data, it’s becoming pretty difficult to justify not raising rates.
That puts Chairman Kevin Warsh in an interesting position.
He’s talked a pretty big game about inflation and the Fed’s commitment to keeping it under control. So if the Fed were to leave rates unchanged this week, I think there’s a real risk that markets begin questioning his credibility.
On the other hand, if the Fed does raise rates, it’ll be very interesting to see how the Trump administration responds.
When Warsh first took over as Fed Chair back in May, President Trump largely stayed out of the way and gave his appointee some room to settle into the job. But more recently, he’s returned to publicly pressuring the Fed over the need for lower interest rates.
So if the Fed raises rates this week, and the president responds the way he has in the past, the honeymoon could be over pretty quickly.
And that puts Warsh in a difficult position as Fed chairman. If the FOMC holds rates steady despite the latest inflation data, he risks facing questions about the Fed’s commitment to bringing inflation under control. On the other hand, if the committee raises rates, Warsh could find himself drawing public disapproval from the president who appointed him.
From an investor’s perspective, the answer matters beyond just whether rates move 25 basis points one way or the other.
The bigger issue is the Fed’s credibility and its independence. Markets, and especially the bond market, need to believe that monetary policy decisions are being driven by the economic data and the Fed’s inflation mandate—not political pressure.
So that’s what we’ll be watching most closely this week.
We’ll see what the Fed decides on Wednesday and, perhaps just as importantly, how both Chairman Warsh and the White House respond afterward. And I’ll look forward to sharing our take on the FOMC meeting in next week’s video.
See you then.
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