Treasury Prepares Another Debt Deluge as Fed Wades Into Market

The U.S. Treasury this week releases the next stage of its strategy to cover a deficit that’s expected to surpass $1 trillion this fiscal year, as the department continues to search for new ways to attract buyers for its record debt issuance.

(Bloomberg) -- The U.S. Treasury this week releases the next stage of its strategy to cover a deficit that’s expected to surpass $1 trillion this fiscal year, as the department continues to search for new ways to attract buyers for its record debt issuance.

It needn’t agonize just yet, however. For the next few months the Federal Reserve will be scooping bills out of the market -- part of its effort to calm the repo market -- about as fast as the government can pour them in.

Dealers roughly agree on the contours of Wednesday’s quarterly refunding announcement. They reckon the Treasury will keep auctions of 3-, 10- and 30-year debt unchanged next week at a record total of $84 billion. Wall Street also expects updates on two proposals: An issue linked to SOFR, which is the benchmark borrowing rate that’s intended to replace Libor, and a 20-year bond.

The wild card is how Treasury may address the elephant in the room. Dealers expect comment on last month’s turmoil in funding markets. And to some extent, the Treasury’s borrowing plans this fiscal year will be viewed, and traded, in light of the Fed’s T-bill purchases to replenish bank reserves. The central bank embarked on the program this month, saying it will run “at least into the second quarter” of 2020 at an initial monthly pace of about $60 billion.

“They’re taking about half of net issuance next year,” said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities.

Some say the Treasury’s relentless debt sales have contributed to a shortage of reserves in the financial system, which last month forced the Fed to resort to a money-market operation it hadn’t deployed since the financial crisis.

Treasury Secretary Steven Mnuchin has rejected that notion, saying this month that the September upheaval had “nothing to do with our issuance.” But the department is clearly curious about how dealers are coping with growing supply. It sought comment in this month’s survey on “the interaction between primary dealer positions, auction participation, and recent repo market variability.”

The Treasury on Monday estimated it will issue $352 billion of net marketable debt from October through December, down from a July forecast of $381 billion.

Debt Bottleneck

The Treasury is “trying to figure out where the bottleneck is, what sort of securities are basically getting stuck on dealer balance sheets,” said Praveen Korapaty, chief global rates strategist at Goldman Sachs.

Dealers have also debated whether the Treasury might tailor its funding plan to the Fed’s bill purchases. Strategists are broadly skeptical that the Treasury might cut coupon sizes -- for the first time since 2016 -- in favor of more bills. They say the Treasury would only have to increase coupons again before long as the deficit expands. What’s more, issuing more bills will simply raise the department’s cash balance, amounting to another drain on reserves.

That would be a case of “the Fed giveth, the Treasury taketh away,” said NatWest rates strategist Blake Gwinn.

Both Goldman and Amherst Pierpont expect instead that the department will rein back bill supply, since securities rolling off the Fed’s balance sheet will be added to the Treasury’s sales.

NatWest’s Gwinn sees a possible indirect impact on debt issuance. He says the decline in rates on securities the Fed targets will in time feed into the Treasury’s models, which would identify those points on the curve as the cheapest to issue.

“So I think it does affect the Treasury, but I think the Treasury tries to avoid a direct response,” he said.

The Treasury avoided explicit coordination with the Fed even during post-crisis quantitative easing. Mnuchin reaffirmed the separation of their roles to reporters this month, saying “our issuance strategy is completely independent” of the Fed’s response to the turmoil in funding markets.

One-Way Deficit

While Wall Street says the Treasury’s stepped-up issuance a year ago leaves it covered for the coming quarters, many dealers expect a widening funding gap toward the end of 2020. The federal deficit is likely to end this fiscal year above $1 trillion, according to the Congressional Budget Office, having narrowly missed that mark in the one just ended. And the shortfall isn’t about to shrink, judging by the apparent lack of appetite for fiscal restraint on either side of the political aisle.

“The deficit hawks have left the Capitol,” said Mark Spindel, chief executive officer of money manager Potomac River Capital.

Deutsche Bank sees coupon sizes rising again heading into 2021, by around $250 billion. Strategist Steven Zeng says this may be an opportune time for a relaunch of the 20-year bond, or a new issue linked to the Secured Overnight Financing Rate. TD expects the latter in roughly mid-2020, followed by a 20-year around the end of that year. Dealers consider that maturity more viable than the Treasury’s proposal for a 50- or 100-year bond, though Barclays and Jefferies are among those saying it could reappear Wednesday, driving the yield curve steeper.

A SOFR-linked issue and a 20-year security topped the list of blue-sky ideas the Treasury solicited from its borrowing advisory committee early this year to help expand and diversify the investor base for its expanding pile of debt.

So far, that expansion hasn’t hurt taxpayers in terms of raising the nation’s borrowing costs. Investors have proven willing to buy positive-yielding debt in the world’s most-liquid bond market, and fears of recession have only spurred that demand.

But if unintended consequences are emerging in the financial system’s plumbing, the Fed’s actions may have a bigger influence on refundings down the road.

Emily Barrett

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