The Treasury promises no more surprises

The US Treasury's February quarterly refunding statement was a small lesson in managing market nerves. Bond investors had been fretting about an ever-larger supply of government debt. The Treasury announced a total refunding of $121 billion, in line with expectations, and said plainly that it does not expect to raise nominal coupon auction sizes for at least several quarters.

How supply became the story

The anxiety dates from last August. At its refunding that month the Treasury raised the size of its coupon auctions for the first time since 2021, just days after Fitch cut America's credit rating from AAA to AA+. Investors realised that the government would have to sell far more long-term debt to finance deficits running at about $1.7 trillion a year, at the same time as the Federal Reserve was letting its own holdings of Treasuries mature without replacing them.

Yields rose steeply through the autumn, and the ten-year Treasury briefly touched 5 per cent in October, its highest since 2007. Much of the rise came from the term premium, the extra return investors demand for holding long bonds rather than rolling over short ones. In November the Treasury increased auction sizes by less than expected at the long end, and yields fell sharply. The episode showed how much the debt managers' choices had come to matter for the bond market.

A pause on longer bonds

By saying coupon issuance has levelled off for now, the Treasury removed the threat of supply-driven jumps in long-term yields that shook bond markets through late 2023. Any extra deficit will be covered by selling more short-term bills. Janet Yellen has calmed the bond vigilantes and bought time, though at the cost of leaning on money market funds to finance the deficit.

The arithmetic of the quarter shows the scale. The Treasury expects to borrow about $760 billion in the three months to March, and the refunding auctions of three-year, ten-year and thirty-year securities account for only a part of that. The rest will come from other coupon auctions and from bills, whose sizes can be adjusted week by week. If the deficit turns out larger than planned, bills absorb the difference.

Who buys the bills

Money-market funds are the natural buyers. Their assets have climbed to records, near $6 trillion, as savers moved cash out of bank deposits to earn more than 5 per cent. Much of that money had sat at the Fed's overnight reverse repo facility, and since last summer funds have shifted it into Treasury bills, which yield slightly more. That shift is why the Treasury could sell a huge volume of bills in the second half of 2023 without disrupting markets.

The capacity is not unlimited. The reverse repo cushion has shrunk from more than $2 trillion to a fraction of that, and once it is gone, new bill issuance must draw money from bank deposits and reserves instead. The Treasury's own advisers have long recommended keeping bills to between 15 and 20 per cent of marketable debt, and the share is already around the top of that range. A strategy that relies on bills for every surprise will push it higher.

A precedent in supply management

The Treasury's decisions have moved markets before. In October 2001, when the government was running surpluses, it announced it would stop issuing thirty-year bonds, and long-term yields fell sharply on the day. The long bond returned in 2006 as deficits reappeared. The Fed's Operation Twist in 1961, and again in 2011, tried to lower long-term rates by shifting the maturity of government debt held by the public. Each episode showed that the mix of maturities affects yields as well as the total amount of borrowing does.

Winners and losers

Holders of long-dated Treasuries gain from the pledge, since it removes one source of upward pressure on yields for several quarters. Mortgage borrowers and companies issuing long-term bonds benefit indirectly. Money-market funds and their investors gain too, since they will have a steady supply of short-term paper yielding more than 5 per cent.

The cost falls on the Treasury's own interest bill and its exposure to rollover risk. Bills currently yield more than ten-year notes, so financing the deficit with short-term debt costs more in the near term, and every bill must be refinanced within a year at whatever rate prevails. If the Fed cuts rates as markets expect, that bet will pay off. If inflation proves sticky and rates stay high, the Treasury will have locked in higher costs on a growing share of its debt.

The case against the pledge

The strongest criticism is that the Treasury is managing optics rather than the underlying problem. The deficit has not shrunk, and the federal debt keeps rising faster than the economy. Pushing borrowing into bills defers the adjustment without avoiding it. Some critics also argue that tilting issuance towards bills to keep long-term yields down amounts to a form of monetary policy that the Treasury should leave to the Fed, especially in an election year.

That criticism is fair about the long run but does not undermine the pledge's short-term effect. The Treasury has always adjusted the mix of its issuance to market conditions, and it said plainly that the pause lasts only for several quarters. The column's point is that the risk has moved, not that it has disappeared.

What to watch

The next refunding, at the start of May, will show whether the pledge holds and whether the Treasury's borrowing estimates rise. The share of bills in total debt, the balance at the Fed's reverse repo facility and demand at long-dated auctions, measured by how much of each sale dealers must absorb, will reveal how the market is coping. Any decision by the Fed to slow the run-off of its bond holdings would ease the pressure.

The Treasury's pledge will keep long-dated supply in check for a few quarters. The financing risk has moved into short-term bills, and it will probably return to the long end once the deficit forces bigger auctions. Expect coupon sizes to stay unchanged through the rest of this year and increases to return next year, when the next administration inherits both the deficit and a bill share well above the advisers' range.