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The Fed changes the Treasury financing outlook

| October 25, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The US Treasury has been comfortable for a while with the outlook for federal financing. Higher issuance implemented over the past few years has left it well positioned to handle likely borrowing well into 2020. But the Federal Reserve’s October 11 announcement of a massive Treasury bill buying program has altered the equation. Suddenly the Fed is going to be a heavy new lender to the Treasury as Fed bill purchases mature and roll over as add-ons in subsequent auctions. The Treasury consequently looks likely to substantially trim its expected bill auctions to offset the Fed’s effect on net borrowing.

Treasury financing outlook

The Fed’s balance sheet announcement earlier this month is a game-changer for Treasury financing, at least in the near term.  The Fed is buying $60 billion in Treasury bills this month, on top of the $20 billion in monthly purchases across the yield curve to replace MBS runoff.  The reinvestment has limited direct implications for Treasury issuance because most of the coupon paper that the Fed is purchasing will not mature for years; Treasury issuance is only affected when Fed open market purchases mature and roll over into auction add-ons.  In contrast, obviously, bill purchases will mature quickly and be rolled over within months, absorbing a noticeable fraction of the Treasury’s FY2020 borrowing needs.  Fed looks likely to buy somewhere around $200 billion in T-bills over the next six months to right-size its balance sheet and then continue to expand the balance sheet by around $100 billion a year afterwards to account for the trend growth in non-reserve liquidity needs—mainly for currency in circulation.

Before Fed’s jumped into bills, it looked like Treasury debt managers were in good shape with the current auction calendar until perhaps late next year.  Now the extra $200 billion coming from Fed add-ons, starting mostly after the turn of the calendar year if the Fed’s pattern of T-bill buying seen so far holds, will require the Treasury to make some offsetting adjustments to its auction sizes.  Debt managers will likely trim bill issuance—not necessarily outright cuts but lower sizes relative to a hypothetical baseline that I had penciled in before—for two reasons:

  • To keep Treasury borrowing in the bill market roughly consistent with what it would have been in the absence of the Fed’s moves. The Treasury will essentially borrow an extra $200 billion in bills from the Fed, so it can trim its issuance to the market by a corresponding amount; and
  • Because the impact of the Fed’s moves on Treasury borrowing will be heavily concentrated in FY2020 and then will fade, it does not make sense to make drastic changes to coupon auction sizes that would have long-lasting implications for meeting borrowing requirements. Even with the Fed covering a little more than $100 billion in the Treasury’s borrowing needs in FY2021 and FY2022, funding gaps of hundreds of billions of dollars for those years will need to be covered by increasing issue sizes across the entire yield curve.  Cutting coupon sizes in FY2020 would not be consistent with Treasury’s historical desire to avoid quick reversals in the direction of auction calendar adjustments.

This narrative also has important implications for the prospect of introducing a new long-dated security.  The refunding agenda released in mid-October suggests Treasury debt managers are strongly considering adding regular issuance of a 20-year bond, presumably, in lieu of an ultra-long bond.  However, if the Treasury chooses to proceed with a 20-year bond in the next few quarters, it would probably have to find offsetting cuts of other issues to make room.  It may be better, even if Treasury debt managers are virtually certain of their intent to proceed with a 20-year tenor, to wait a few quarters until financing needs call for expanding gross issuance anyway.  Such a patient approach would be consistent with the timeline for many prior introductions of new (or renewed) securities, as it would give Treasury debt managers plenty of time to solicit feedback, determine the desirability and the proper details of a new tenor, and offer ample advance notice so that Treasury market participants have adequate time to prepare.

A 20-year bond

In a surprising move, just a couple of months after announcing a reopening of the inquiry into the desirability of an ultra-long bond, Treasury debt managers shifted gears in the refunding agenda and asked about the wisdom of bringing a 20-year bond, presumably instead of a 50-year or 100-year bond.  The feedback Treasury solicited from market participants regarding an ultra-long bond presumably was overwhelmingly negative, which does not seem especially surprising.  Treasury debt managers have canvassed the Street several times in recent years on the topic and the answer has always been the same: demand would be limited and it is doubtful that an ultra-long bond could be large and liquid enough to achieve benchmark status.

In contrast, there is some history with a 20-year bond.  Treasury issued them in the early 1980s, but they were discontinued after 1985 so that the last one matured well over a decade ago.  There is certainly natural demand in the long end, especially from insurance and pension investors.  The support from the corporate bond community has been especially vocal, but it is not clear whether that group will actually be a major buyer of 20-year Treasuries.  Instead, they want it mainly as a pricing benchmark for new corporate bond issuance.  In any case, a 20-year instrument would fill a need for long-end investors.  The alternative now in the cash market is a set of deep off-the-run bonds with limited float due to heavy Fed buying during the various rounds of QE and buy-and-hold ownership in either stripped or whole bond form, so an active and liquid benchmark in the sector would be welcome.  The downside argument is that most investors who need long-term assets have figured out how to make do with a combination of cash 10s, cash 30s, bond futures, and ultra futures.  Thus, if there were to be a substantial migration into a 20-year Treasury bond, it would probably cannibalize to some degree the demand for other securities.  Put differently, it is unclear that a 20-year Treasury bond would bring in new buyers of Treasury debt that did not exist before.

It will be interesting to hear whether Treasury expresses a view on reviving a 20-year bond in the upcoming refunding announcement or is simply gathering information at this stage.  The wording of the refunding agenda question made it seem that Treasury is pretty far along the road of deciding to add a 20-year bond, a surprising development given that there had been no previous discussion of it.  As noted above, however, the outlook for funding needs changed dramatically on October 11, and Treasury debt managers may or may not have been privy to what the Fed had in mind when they crafted the agenda question.  There is no pressing need to add net issuance at this time, so Treasury officials have the luxury, if they elect to use it, of taking their time before making a final decision on whether to add a 20-year bond.

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