Treasury protects the long end of the curve

admin | November 6, 2020

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.

As the government in recent months has attempted to term out the borrowings needed to fund its Covid response, the Treasury market has begun to show modest signs of stress absorbing heavy coupon issuance. Auctions have become a bit more difficult particularly in the longer end of the yield curve. Treasury debt managers responded on November 4 by dramatically slowing the increase in coupon auction sizes over the next three months. To the extent this helps rein in any supply-related backup in longer rates, it may forestall any need by the Fed to speed up asset purchases or concentrate buying in the long end of the yield curve, as it did during the rounds of QE nearly a decade ago.

Terming out the debt

The CARES Act dictated that hundreds of billions of dollars of federal spending would go out the door in a matter of weeks as tax rebate checks, bonus unemployment benefits and support for businesses. Treasury also delayed the April 15 deadline for individual and corporate income tax payments by four months, depriving the government of a massive source of revenue at virtually the same time.

As a result, the Treasury had to borrow a lot of money and had to do it in a great hurry. The only practical option was to raise the bulk of the money in the short end of the curve, primarily in bills, a strategy made far easier by the Fed’s policies, with the funds rate target at the zero bound and massive amounts of excess liquidity poured into the system through asset purchases and special lending.

Since the spring, Treasury debt managers have been terming out that debt, incrementally raising coupon auction sizes to lock in low rates and securing term funding. Within the Treasury’s strategy of being “regular and predictable,” however, it can only implement that approach over time, as, traditionally, coupon auction sizes are only raised and lowered gradually.

At its previous quarterly refunding announcement in August, Treasury officials chose to weight their supply increases toward the long end. While Treasury raised the 2-, 3- and 5-year auctions by $2 billion each month, 7-year auctions rose by $3 billion per month and 10-, 20- and 30-year coupon auctions rose by $6 billion, $5 billion and $4 billion respectively above the prior quarter’s levels.

The hefty increase in supply since the pandemic began to introduce mild stress as in recent months yields have backed up during auction weeks to make it more palatable for investors to take down such a large amount of paper. The supply concessions have been mild, usually a handful of basis points, and temporary, as the market has also seen a number of relief rallies once auctions completed successfully. Nonetheless, the size and clarity of auction concession was well beyond what has been the norm over the past few decades.

A shift in strategy

Treasury debt managers were evidently sufficiently concerned with the apparent stress in the long end of the market that they adjusted their approach. The November 4 quarterly refunding announcement included a let-up in the increases in longer-term supply. While Treasury kept the pace of coupon auction size hikes steady for 2-, 3-, 5- and 7-year maturities, it cut the amount of the increase in longer-term coupon auctions for the next three months. From November through January, 10-year auctions will be $3 billion larger than a quarter ago, 20-year auctions will be $2 billion larger and 30-year auctions will be $1 billion larger.

That represents a deceleration of more than half in the long-end supply hikes, from a total of $45 billion in the August-through-October quarter to $18 billion for November through January. The Treasury market reacted significantly, as the yield curve flattened noticeably in the wake of the announcement.

Implications for the Fed

While the Treasury’s moves were important for the financial markets directly, as witnessed by a significant reaction, even in the midst of the election whirlwind, they also potentially have implications for the Fed’s stance on asset purchases. Having locked in forward guidance for rate policy and projected sitting at the zero bound through at least the end of 2023, the Fed’s only option for tweaking monetary policy going forward, aside from its extraordinary lending facilities, is to alter its asset purchase program.

Chairman Powell acknowledged after the November FOMC meeting that the committee turned to the topic and discussed its options while not yet coming to any final decisions. Ultimately, the Fed needs to offer more explicit forward guidance on what would lead it to alter its asset purchases—either increasing or decreasing the pace or altering the composition or duration of it buying of a mix of these possibilities. One option frequently discussed among market participants is for the Fed to skew its Treasury purchases more toward the long end of the yield curve, as it did in the early-2010s QE rounds, to lower long-term interest rates.

With the 10-year Treasury yield currently trading at well below 1%, it would be difficult to argue that there is a pressing need for the Fed to try to create more accommodative financial conditions. If rates were to begin to rise, the Fed’s response would likely depend in large part on the reason for the backup. If investors begin to believe that the economy is on a stronger track than previously thought—for instance, if successful vaccines begin to be administered—then it would seem unlikely that the Fed would object to such a move.

In contrast, if long-term yields are rising for other reasons, while the economic outlook had not materially brightened, then the Fed might want to push back against that by tweaking its asset buying program. The prime candidate for such a scenario is probably a supply-related rise in yields, as investors’ unwillingness/inability to take down sharply larger auctions without a more substantial concession could lead to enough of a move to motivate a Fed response. By cutting back noticeably on the pace at which long-end supply will be rising over the next three months, Treasury debt managers have, at the margin, lowered the odds of such an outcome, at least for the time being.