The Treasury blinks

The US Treasury said on 31 October that it would borrow $776 billion in the coming quarter, well below the $852 billion Wall Street had feared, and that it would lean more heavily on short-dated bills. With ten-year yields close to 5.0 per cent and the bond market struggling to digest supply, it was a tactical retreat.

Why the Treasury had to move

The pressure had been building since the summer. At its August refunding the Treasury raised the size of its longer-dated auctions for the first time since 2021, and the long end of the market took fright. The ten-year yield rose from about 4 per cent in July to within a whisker of 5 per cent in October, and several auctions of long bonds cleared only with a yield concession. Fitch's downgrade of America's credit rating in August and the chaos in the House of Representatives added to the unease. Further increases in coupon auctions at the same pace would have tested a market that was already failing to find buyers.

Bills over bonds

Selling bills rather than flooding the market with long-dated coupons let Janet Yellen's department draw cash out of the Fed's Overnight Reverse Repo facility, which spared bank reserves an immediate squeeze. In effect the Treasury went around a hostile market for long bonds by issuing paper that money market funds could easily buy. Bonds rallied hard across the curve as soon as the plan was published.

The plumbing explains why this works. Money-market funds park spare cash at the Fed through the reverse repo facility, earning the Fed's policy rate. When the Treasury offers bills at a slightly higher yield, the funds move that cash out of the facility and into bills, and the government's cash account fills without draining reserves from the banking system. The facility's balance has already fallen by more than half from its peak, as funds shifted into the heavy bill issuance that followed the debt-ceiling deal in June. What remains is the buffer that lets the Treasury keep leaning on bills without squeezing bank liquidity.

A trick with a history

Shortening the maturity of issuance to relieve the long end is not new. In October 2001 the Treasury stopped selling 30-year bonds altogether, arguing that a shrinking need for borrowing made them unnecessary, and did not bring them back until 2006. The Fed ran its own version in 2011, selling short-dated Treasuries and buying long ones in an exercise nicknamed Operation Twist to push down long-term yields. Both episodes show that the mix of debt a government sells can move the shape of the yield curve, at least for a while.

Who gains and who pays

The immediate winners are holders of long bonds and borrowers whose costs are tied to long yields. Mortgage rates, which had approached 8 per cent, price off the ten-year Treasury, and companies issuing long-dated debt benefit from any drop in the benchmark. Stocks, whose valuations had been squeezed by rising discount rates, also stand to gain from a lower term premium. Money-market funds win too, since more bills mean more high-yielding paper to buy.

The cost falls on future budgets. Bills mature within a year, so their interest cost resets quickly with the Fed's policy rate. At a funds rate of 5.25 to 5.50 per cent, the Treasury is locking in short-term financing at the highest cost in more than two decades and must roll it over again and again. If the Fed keeps rates high for longer than markets expect, the interest bill will rise faster than it would have with longer-dated debt. A heavier reliance on bills also makes the government's finances more sensitive to any jump in short-term rates, which is precisely the risk that fiscal planners usually try to avoid.

The case for the manoeuvre

The counterargument deserves weight. If the Fed begins to cut rates next year, as futures markets expect, bills will become cheaper to roll, and the Treasury will have avoided locking in ten- and thirty-year debt at the highest yields in sixteen years. Many officials would regard that as prudent debt management. The Treasury's advisory committee of dealers has also long accepted that the share of bills can drift upward temporarily when borrowing needs jump.

That defence depends on a forecast. If inflation proves sticky and the Fed holds rates at their current level through next year, the bet on bills will cost more, not less. The larger issue is that the deficit itself has not changed. The Treasury has altered the form of its borrowing, not the amount, and the supply of long-dated debt will have to rise again once the bill buffer is used up.

What to watch

The details of the refunding, due on 1 November, will show how quickly the Treasury plans to increase coupon auctions from here. The Fed's policy decision the same day will show whether officials see the recent rise in yields as a substitute for further tightening. Beyond that, the balance of the reverse repo facility is the gauge of how much room remains for bill-heavy financing.

The shift to bills was clever liquidity management. Funding a deficit of several trillion dollars with short-term paper is still only a stopgap, and the Treasury will have to refinance a growing pile of bills at whatever rates prevail next year, with taxpayers carrying the risk if the Fed keeps rates high.