The Big Idea

Commercial paper and Treasury debt lead US supply

| June 14, 2024

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.

Rising balances in commercial paper and Treasury debt helped push US debt securities outstanding in the first quarter to nearly $60 trillion, or slightly less than 40% of total global debt securities. And although CP growth has since slowed, Treasury balances keep rising. Steady Treasury supply opens the door to even tighter spreads in risk assets, and the size and diversity of the US debt market should continue drawing global investment flows. Demand from brokers, money funds, banks, insurers, ETFs and mutual funds continue absorbing the supply and supporting tighter spreads and a steeper curve.

Supply: Growth in commercial paper, Treasuries lead a $60 trillion market

Repricing and net issuance pushed up the value of US debt securities in the first quarter this year by $885 billion or 1.5%, based on the recently released Financial Accounts of the United States. That’s in line with 5.9% growth in debt securities for all of last year and puts the total value of US debt securities at nearly $60 trillion.

Commercial paper set the fastest pace among the different sectors of debt securities in the first quarter, up 4.1%, along with Treasury securities, up 2.2% (Exhibit 1). Corporate and structured credit and foreign debt matched the average pace at 1.5%. Muni debt, at 0.6%, and agency debt and MBS, at 0%, trailed.

Exhibit 1: CP, Treasury and credit markets lead, muni and agency trail

Source: Financial Accounts of the United States, Santander US Capital Markets.

The growth in commercial paper mainly reflected a rise in outstanding balances from US companies, foreign banks and issuers of asset-backed securities, although foreign bank issuance has since cooled. The issuance likely came in response to good demand from prime money market funds, which have seen balances rise to their highest levels in eight years. The Treasury market reflects current heavy fiscal deficit spending.

Supply: Tighter spreads between Treasury, risk assets

The fast pace of growth in Treasury debt, all else equal, should keep narrowing the yield spread between the Treasury curve and risk assets. Even though many risk assets, credit in particular, trade at the tightest levels in five years or more, Treasury issuance promises to tighten spreads further. Work by the Treasury Borrowing Advisory Committee, the World Bank and other consistently finds that Treasury supply affects spreads in swaps and other risk assets. Measured either directly as outstanding debt as a share of GDP or indirectly as the federal deficit as a share of GDP, heavy supply tends to coincide with narrower spreads. In other words, Treasury yields rise relative to swaps. And light or falling supply coincides with wide spreads as Treasury yields fall relative to risk assets. In the first quarter this year, marketable Treasury debt as a share of US GDP grew by more than 1%.

Supply: Growing global US debt footprint

With US debt still growing faster than the 1.3% pace of nominal US GDP in the first quarter, the market is likely to expand its global debt market footprint. According to the Bank for International Settlements, US debt securities at the end of last year made up 38% of the global total (Exhibit 2). China, the second largest market, made up 16%, and Japan, the third largest, made up 8%. The size, liquidity, and range of rating and risk exposures in the US market continue to draw global debt investors. Foreign investors in the last year have been heavy investors in both US Treasury and corporate debt and structured credit.

Exhibit 2: US debt securities’ 38% share of global total likely to grow

Source: Bank for International Settlements, Santander US Capital Markets.

Demand: Brokers, money funds, banks, P&C, ETFs and funds lead

Demand for US debt securities in the first quarter showed some similarity to the picture from last year with the notable exception of banks, which switched from shrinking their securities portfolio last year to growing it in the first quarter. Some highlights of first quarter demand (Exhibit 3):

  • Broker dealer holdings showed the fastest growth, up 21% in the first quarter. Treasury securities rose $35 billion, agency debt and MBS rose $39 billion and corporate debt, structured credit and foreign bonds rose $14 billion. Brokers at the end of the quarter held $541 billion in debt securities. Weekly reports from the New York Fed show primary dealer balance sheets continue to grow into June and are near their highest level in more than 10 years. With the heavy Treasury issuance, dealer balance sheets are likely to keep growing. And since dealers typically finance their Treasury positions, demand for Treasury repo is likely to climb, too.
  • Money market mutual funds grew 9.6% in the first quarter, with balances at a record $6 trillion. High yields on the Fed’s reverse repo facility, on bilateral repo, Treasury bills, commercial paper and other money market instruments have drawn cash out of the banking system and have led investors to allocate from other risk assets into money market funds.
  • Banks also grew faster than the aggregate debt securities market with foreign banks up 4.5% and US banks up 2.0%. Based on the Fed’s weekly H.8 report, most of the rise in bank securities holdings has come in Treasury debt, up during the first quarter and continuing through May by 3.45%; holdings in agency MBS have been flat
  • P&C insurers also grew faster than average at 3.3% with good demand for highly rated, short corporate debt
  • ETFs grew at 2.6% and mutual funds at 1.8%, with the aggregate demand for debt securities in line with weightings in broad debt market indices

Exhibit 3: Brokers, money funds grew quickly in the first quarter, the Fed shrank

Source: Financial Accounts of the United States, Santander US Capital Markets.

The most material demand shift in recent months is the swing to growth in bank investment portfolios, although most of that is happening in Treasury debt rather than banks’ traditional core market in agency MBS. Banks hold $5.1 trillion in debt securities, or 8.5% of the US total, so changes in demand can quickly make a difference. The swing reflects modest loan demand and regulatory pressure to shorten balance sheet duration and improve liquidity.

Balancing supply and demand

Growth in supply and demand in different sectors relative to GDP should track potential repricing across the US debt securities markets. A few implications of the latest numbers:

  • Commercial paper looks unlikely to keep up its first quarter pace of growing more than three times faster than GDP and should fall back in line, as it did last year. Demand for commercial paper from money funds, growing more than seven times GDP, should also slow but trend above GDP as long as the Fed keeps short rates high. Look for demand to outstrip supply and CP spreads to tighten.
  • Treasury debt looks likely to continue growing faster than US and global GDP—also the expectation of the Congressional Budget Office—exerting steady pressure on yields. Recent relatively fast growth in money fund and bank portfolios has supported demand for Treasury bills and shorter Treasury notes for now, but demand for longer notes and bonds eventually may struggle to keep up—especially as QT continues. This should bias the yield curve steeper.
  • Corporate debt and structured credit should grow in line with GDP, but demand from insurers reflects rising premiums and strong annuity issuance and should keep credit spreads tight. Faster growth in Treasury debt relative to credit should also pressure spreads tighter.
  • A relatively slow pace of growth in muni debt and in agency debt and MBS argues for tighter spreads, but declining bank demand in recent years has hurt these markets and Fed QT has further hurt agency MBS. Recent growth in aggregate bank portfolios has bypassed MBS in favor of Treasuries, so slow growth in supply and slow demand argues for steady spreads in MBS.

* * *

The view in rates

Fed funds futures now price in 50 bp of easing this year as of the Friday close, up 14 bp in the aftermath of a May core CPI with only a 0.2% month-over-month increase. The market sees a 68% chance of September and a 82% chance of December. The Fed keeps saying it will need to see several months of benign inflation readings, but May starts the clock.

Other key market levels:

  • Fed RRP balances closed Friday at $387 billion. RRP balances have bounced between $400 billion and $500 billion since the start of March. That range has held despite yields on most Treasury bills running well above the RRP’s 5.30% rate.
  • Setting on 3-month term SOFR closed Friday at 534 bp, up 1 bp in the last week.
  • Further out the curve, the 2-year note closed Friday near 4.70%, down 17 bp in the last week. The 10-year note closed at 4.22%, down 21 bp in the last week.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -48, flatter by 3 bp in the last week. The 5s30s closed Friday at 11 bp, steeper by 2 bp over the same period
  • Breakeven 10-year inflation traded Friday at 218 bp, down 12 bp in the last week. The 10-year real rate finished the week at 204 bp, down 10 bp in the last week.

The view in spreads

Implied rate volatility has bounced higher lately, putting temporary pressure on risk asset spreads. Credit still has the most momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risk and riskless.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 90 bp, wider by 1 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 144 bp, 1 bp wider on the week. Par 30-year MBS TOAS closed Friday at 34 bp, tighter by 3 bp in the last week. Both nominal and option-adjusted spreads on MBS look rich but likely to remain steady on low supply and low demand.

The view in credit

Higher interest rate should raise concerns about the credit quality of the most leveraged corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress, with most metrics renormalizing back to late 2019 levels. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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