The Big Idea
Treasury supply math
Stephen Stanley | October 29, 2021
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.
Two events with major implications for US Treasury supply will both occur on November 3. In the morning, the Treasury will issue its quarterly refunding statement after signaling in August it would begin cutting coupon auction sizes in November. Then in the afternoon, the FOMC should announce the tapering of its asset purchases. These events have opposite impacts on the amount of available Treasury supply. Smaller auction sizes reduce net supply while waning Fed purchases, all else equal, mean private investors have to hold more Treasury paper. As it happens, the two changes may come close to exactly offsetting each other.
Treasury supply changes
Treasury debt managers were forced to ramp up coupon auction sizes last year to pay for the massive expense associated with the pandemic. Annual budget deficits surged from about $1 trillion in 2019 to around $3 trillion in 2020 and 2021. With pandemic relief now mostly ended and tax revenues increasing rapidly as the economy recovers, the budget deficit for 2022 may narrow to less than $2 trillion.
As a result, Treasury debt managers need to recalibrate their issuance schedule for smaller net borrowing. In the August Treasury refunding statement, Assistant Treasury Secretary Brian Smith noted that he expected “an initial set of auction size reductions” would be announced as soon as the November refunding.
Treasury will likely make such an announcement this week. Look for auction size reductions to mirror the increases implemented last year. Specifically, I am projecting cuts of $2 billion a month for 2-, 3- and 5-year notes, $3 billion a month for 7-year notes, $3 billion a quarter for each 10-year auction and $2 billion a quarter for each 20- and 30-year and 2-year Floating-Rate note auction. I have continued that pace of reduction from November through April 2022 and then added one more quarter of smaller cuts from May through July, with coupon auction sizes stabilizing in August 2022. The impact on quarterly gross Treasury coupon supply ranges from reductions between $29 billion to $113 billion (Exhibit 1)
Exhibit 1: Treasury Supply Reduction
While the Treasury may begin to reduce its new issuance, the Fed is poised to shrink its footprint in the Treasury market. Since the early days of the pandemic, the Fed has been buying $80 billion in Treasury securities each month. The FOMC is expected to announce on Wednesday that it is going to begin tapering the pace of its purchases.
I look for the Fed to lay out a schedule that entails reductions of $10 billion a month for Treasury securities and $5 billion a month for MBS. At that pace, it would take eight months to end asset purchases. I actually believe that there is a risk that the Fed is forced by persistently high inflation to accelerate the program and end QE a few months earlier, but, for the sake of this exercise, I will assume that the Fed carries out its reductions with a series of eight equal monthly cuts, ending asset purchases in June.
The Fed’s monthly asset purchase schedules are actually published around mid-month so that MBS buys can be calibrated to the monthly speed reports. Thus, for each calendar month, Fed purchases will be halfway between the old and new pace. For example, if the FOMC implements its initial taper as of the November schedule date, then the Fed will buy roughly $75 billion in Treasuries—the first half of the month at an $80 billion pace and the second half at a $70 billion pace. Quarterly purchases of Treasuries over the next four quarters should fall by between $20 billion and $90 billion (Exhibit 2)
Exhibit 2: Fed tapering of Treasury purchases
Combining the two influences on the amount of Treasury supply available to the public, it is striking how close they come to exactly canceling each other out. The cumulative cut in Treasury coupon auctions implied by the program laid out above amounts to $260 billion, while over roughly the same time period, the quarterly pace of Fed buying will go from $240 billion to zero. Even on a quarter-to-quarter basis, the changes are remarkably similar (Exhibit 3).
Exhibit 3: Comparing issuance cuts to Fed tapering
Normally, the prospect of significant reductions in Treasury auction sizes would, all else equal, be a meaningful bullish event for the market. In contrast, the likelihood of the Fed pulling out of the Treasury market would have notable bearish implications. It may be a pure coincidence, but both the timing and magnitude of these two events over the next few quarters almost exactly cancels out. Treasury yields will undoubtedly move substantially over the next several quarters, but investors probably do not need to worry much about the pure supply implications of smaller Treasury auctions or Fed tapering.