- Wall Street bond dealers predict 27% decrease in net issuance
- Drop-off may keep a lid on long-term U.S. yields as Fed looms
Lost in the debate over the U.S. Treasury market’s resilience as the Federal Reserve starts to raise interest rates is one simple fact: supply is falling -- and fast.
Net issuance of U.S. notes and bonds will tumble 27 percent next year, according to estimates by primary dealers that are obligated to bid at Treasury debt auctions. The $418 billion of new supply would be the least since 2008.
While a narrowing budget deficit is reducing the U.S.’s funding needs, the Treasury has shifted its focus to T-bills as post-crisis regulations prompt investors to demand a larger stock of short-term debt instead. The drop-off in longer-term debt supply may keep a lid on yields, providing another reason to believe Fed Chair Janet Yellen can end an unprecedented era of easy money without causing a jump in borrowing costs that derails the economy.
“Longer-term yields will be slower to move up next year because the Treasury will be funding more with bills,” said Ward McCarthy, the chief financial economist at Jefferies Group LLC, who has analyzed U.S. debt markets for over three decades and was a senior economist at the Richmond Fed. “There is also a global appetite for Treasuries as U.S. debt is one of the world’s highest-yielding and is among the most liquid markets.”
Excluding bills, Jefferies forecasts net issuance of $404 billion in 2016, down from their $607 billion estimate for this year.
Of the ten estimates compiled by Bloomberg, the Bank of Montreal was the lone primary dealer calling for an increase in 2016. Net issuance of interest-bearing securities, or those with maturities from two years to 30 years, has fallen every year since the U.S. borrowed a record $1.61 trillion in 2010, data compiled by the Securities Industry and Financial Markets Association show.
Deutsche Bank AG says net sales could even fall as low as $293 billion, based on a scenario where the Treasury reduces debt auctions by 8 percent across the board to make room for more bills. That would represent a more than 50 percent drop from the bank’s 2015 projection of $629 billion.
After the market for Treasuries more than doubled since the financial crisis to $12.8 trillion as the government ran deficits to bail out banks and support the economy, the U.S. has started to scale back supply.
One reason is the narrowing budget gap. With the Fed holding its benchmark rate near zero since December 2008, the jobless rate has fallen by half from its post-crisis peak in 2009, to 5 percent today. As tax revenue increases, the Congressional Budget Office forecasts the shortfall will narrow to $414 billion in the fiscal year ending Sept. 30, 2016, from $439 billion in the previous 12 months and $483 billion in the prior annual period.
To lock in record-low long-term borrowing costs, the government has also lengthened the average maturity of its debt to 5.8 years from 4.1 years at the end of 2008. One consequence is that the Treasury market’s share of bills has shrunk to about 10 percent, the smallest in Bloomberg data going back to 1996.
The Treasury and Wall Street strategists say it’s now time to reverse that to build the government’s stores of cash and as post-crisis regulations increase demand for ultrasafe, short-term assets like bills.
“The Treasury had previously focused on raising the maturity of their debt,” said Jay Barry, a U.S. fixed income strategist at JPMorgan Chase & Co. Now, “they can focus on increasing bill issuance as demand is set to rise.”
The government will boost bill supply by $173 billion in 2016, according to JPMorgan, another primary dealer. That would be the biggest increase since 2008. The bank also sees net Treasury sales of coupon-bearing securities falling to $313 billion next year, compared with their 2015 estimate for $627 billion.
The dwindling net issuance may keep Treasury yields in check as the Fed moves to raise rates for the first time since 2006.
While traders are pricing in a 72 percent chance the Fed will lift rates from near zero in December, they still see the rate below 1 percent in a year’s time. Forward rates imply that traders also expect yields on 10-year notes, used to set interest rates on everything from mortgages to corporate bonds, will rise to about 2.5 percent over the same period -- less than 0.3 percentage points above the level of 2.22 percent today.
Still, demand for Treasuries could diminish because of increased competition from corporate borrowers, according to Aaron Kohli, a fixed-income strategist at Bank of Montreal. They’ve sold $1.5 trillion of bonds this year, a record pace, focusing on longer-maturity securities before the Fed starts its tightening cycle.
And the picture would change rapidly if the Fed decides to stop reinvesting the money from the maturing debt it owns back into Treasuries. The Fed has amassed $2.5 trillion in Treasuries, largely from its quantitative-easing programs, and has $216 billion of the debt coming due in 2016.
On the other hand, Fed officials have repeatedly said they will raise rates gradually, which may ultimately help avert a sudden selloff in bonds. Mutual fund investors bought a record 42 percent of the $1.6 trillion in notes and bonds sold at auctions through September, up from 18 percent in 2011.
Treasuries will be underpinned by the fact that yields on 10-year notes are already higher than 18 of 25 developed countries tracked by Bloomberg and the highest among the Group of Seven nations. The yield advantage over comparable German bunds reached 1.78 percentage points Nov. 20, the most since April.
“We are in a new environment where low yields are the norm,” said Mike Lorizio, a Boston-based fixed-income trader at Manulife Asset Management, which oversaw $313 billion as of June 30. Lorizio has been a buyer of Treasuries this year and sees value in 10- and 30-year debt. “So Treasuries look attractive.”
Estimates for 2016 net issuance of Treasury coupon securities:
- Deutsche Bank -- $293 billion *
- JPMorgan -- $313 billion
- Nomura -- $323 billion
- Citigroup -- $402 billion
- Jefferies -- $404 billion
- Morgan Stanley -- $407 billion
- Barclays -- $420 billion
- TD -- $472 billion
- Credit Suisse -- $560 billion
- Bank of Montreal -- $585 billion
Note: Deutsche Bank’s estimate assumes an 8% cut in coupon auctions.