by Chris Black
The Quarterly Refunding Announcement sparked a sizable decline in Treasury yields, but this bond rally may not last. The announcement was well received because it guided towards just one more increase in coupon sizes, a compositional skew towards medium term tenors, and a potential for further increases in the share of bills as the RRP is drained to near-zero.
These developments were positive relative to expectations, but the situation remains dire .
The bond bear market may resume shortly as historically high levels of coupons will still be issued (home.treasury.gov/system/files/221/Tentative-Auction-Schedule.pdf) at a time when private demand appears weak and the Fed is not yet in the market.
Further upward pressure on yields is likely as private investors must absorb $2.5t in issuance in the coming fiscal year.
Privately held marketable borrowing is a function of the fiscal deficit and quantitative tightening (QT) (fedguy.com/quantitative-tightening-step-by-step/), where Fed Treasury holdings are refinanced by private investors.
The annual fiscal deficit is currently estimated at $1.8 trillion, though estimates have been steadily increasing (home.treasury.gov/system/files/221/TreasuryPresentationToTBACQ42023.pdf).
Rising interest rates and additional war related spending (www.bloomberg.com/news/articles/2023-10-17/white-house-eyes-100-billion-ukraine-israel-and-border-ask) could lead to upward revisions in the coming months.
Treasury QT is proceeding at a maximum annual pace of $720b (www.federalreserve.gov/newsevents/pressreleases/monetary20220504b.htm).
Both the deficit and QT are subject to change, but at the moment they together imply $2.5t in private borrowing for the 2024 fiscal year.
Private borrowing is estimated to be lower in subsequent years, but that is only on the assumption of an end to QT, which as of lately the Fed signals they will continue QT (t.me/marketfeed/427665) even through the next recession.
The Treasury has responded to this challenge by raising coupon auction sizes and also shifting debt composition towards bills .
The Treasury began raising coupon auction sizes in August (home.treasury.gov/news/press-releases/jy1671) and signaled additional increases over the next quarters. The recent November refunding announcement further increased auction sizes, but guided towards just one more quarter of increases (home.treasury.gov/news/press-releases/jy1864).
The Treasury was advised in August to increase their share of bills towards 22.4% (home.treasury.gov/news/press-releases/jy1670), which is above its historical guidelines of a 15 to 20% share.
Recent issuance (home.treasury.gov/system/files/221/TBACRecommendedFinancingTableQ42023-11012023.pdf) has indeed been skewing towards bills, which are more easily digested by the market.
Treasury was further advised in November to allow bills to “meaningfully ” deviate from its historical guidelines.
But coupon issuance is expected to remain large even with higher bill issuance.
The share of bills is set to gradually rise next year, but the trajectory of the increase may not be aggressive enough to support the market.
Under the recommendation of the Treasury Borrowing Advisory Council (home.treasury.gov/policy-issues/financing-the-government/quarterly-refunding/treasury-borrowing-advisory-committee-tbac) (TBAC), the amount of new money raised next calendar year through coupons would be around $1.8t.
Assuming $2.5t in privately held borrowing for 12 calendar months, net bill issuance next year looks to be around $700b. This would take some pressure off the market by increasing the share of bills to around 22% of marketable debt outstanding.
TBAC’s guidance appears to indicate bill share could continue to rise beyond next year into the medium term, but that does not provide immediate relief. Private coupon holdings next year is still expected to increase at a historically high rate.
The level of coupon issuance may still overwhelm the market even as the share of bills rises. TBAC is recommending gradual increases in coupon sizes over the next months until April 2024.
At that time, the monthly pace in coupon issuance would be $100b higher than July 2023, just prior to recent increases.
The Treasury is mindful of potential market pressure and is skewing increases towards the more liquid belly of the curve, but issuance in less liquid longer dated tenors looks to still gradually increase to record levels.
The recent bond rout suggests current demand for Treasuries is not strong, so the on-going increases in issuance may not be well digested.
Treasury yields are likely to resume their climb unless investor demands picks up significantly for some reason.
Treasury coupon demand next year could be boosted by Fed rate cuts or a moderate recession, both of which are reasonably likely to expect.
Fed rate cuts would steepen the curve and offer investors more reason to invest further out along the curve, like on 20-year bonds.
It would also make Treasuries more attractive to FX-hedged foreign investors.
The September dot plot shows that the Fed has already guided towards two cuts (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230920.pdf) next year, and rising longer dated yields may produce enough tightening to prompt more.
A recession usually increases demand for Treasuries as investors become risk averse and flee to a safe haven , though it also implies lower tax revenue and thus higher issuance (a larger deficit).
A recession and rate cuts would likely boost Treasury demand, but current U.S. economic strength suggests they are more likely to occur later next year after the market is forced to digest a significant amount of debt issued by the Treasury.
The more likely sequence may be a sharp rise in yields that then leads to both a recession and rate cuts, which together finally create strong demand for Treasuries.