Goldman: Potential Relief On 20s From Auction Cuts Likely Short-Lived

Goldman Sachs note that “among the questions facing Treasury heading into the May refunding meeting is what to do at the 20-Year point. Our base case is for an additional $2bn cut to auction sizes versus the current cycle, larger than the $1bn reductions we have pencilled in for 10s and 30s, mainly on account of the liquidity challenges in that sector (we also assume a $1bn cut to 7s). Due to a range of factors, including (but not limited to) its illiquidity, the point has traded persistently cheap on the curve, though the relative resilience year-to-date has been notable amidst a market environment that would have implied further cheapening. Higher unit risk premium is consistent with 20s underperforming on the 10s20s30s fly (given the larger duration increase going from 10s to 20s compared to from 20s to 30s), while the smaller convexity gain of going from 10s to 20s versus 20s to 30s means that a higher rate vol backdrop should also see 20s underperform. Since the start of the year, rates liquidity has broadly worsened, implied vol on longer tails has risen materially (1y20y up by over 20bp), and 10y term premia estimates show an increase on the order of 20-30bp, yet the 10s20s30s U.S. Tsy fly is close to unchanged. While a larger cut to the 20s or firming demand in that sector could be a tailwind in the near term (by compressing liquidity premium), we do not think 20s can richen materially so long as the current volatile environment persists.”