US ‘Term Premium’ Shock May Require T-Bill Surprise: McGeever, Reported by Reuters

By Jamie McGeever

ORLANDO, Florida – The U.S. Treasury may be inclined to focus on short-term debt in response to shifting market conditions.

Traditionally, Treasury’s debt management isn’t swayed by market timing; however, the return of a long-absent "term premium" could lead to more short-term bill sales in the upcoming year than initially anticipated.

The upcoming Quarterly Refunding program, set to be announced on November 1, coincides with rising deficits and increasing interest rate burdens, significantly heightening Treasury’s funding requirements.

A key consideration is where on the maturity curve the Treasury will allocate additional borrowing to stabilize an increasingly volatile bond market.

The Treasury aims for a "regular and predictable" debt issuance strategy that minimizes costs to taxpayers over time. It is expected to significantly boost the issuance of longer-term bonds, beyond 12 months, in the fiscal year 2024 to counterbalance this year’s surge of $1.6 trillion in short-term bill sales.

Increased liquidity management requirements, the Federal Reserve’s tightening measures, and overall government funding necessities suggest a rise in net bond supply across various maturities.

However, it appears that the long-end of the yield curve may not rebound as much as previously expected. Long-dated bonds have faced significant declines since the last refunding announcement in August, resulting in borrowing rates reaching levels not seen since 2006-07.

The increase in costs for long-term debt capital has raised concerns about sustainability, contributing to the resurgence of the "term premium." This premium serves as compensation for the inherent uncertainties associated with long-term bonds compared to short-term bills, reflecting risks that extend beyond predictions related to inflation or policy rates.

According to estimates from the San Francisco Fed, the term premium on the 10-year Treasury bond has escalated by approximately 100 basis points since July, while a New York Fed model places the increase at around 125 basis points—the highest in eight years. This uptick has steepened the yield curve by roughly 85 basis points over the same timeframe.

Analysts at Morgan Stanley suggest that the growing term premium and sustainability concerns could lead to a reassessment of the balance between bill and bond supply. They noted, "Historically, the Treasury has not been known for reacting swiftly to market conditions. However, the recent sharp rise in yields and term premiums is noteworthy," predicting an increase in T-bill issuance in the coming quarters compared to earlier forecasts.

They estimate an extra net bill supply of approximately $750 billion for the calendar year 2024. Similarly, analysts at other financial institutions project net bill issuance at around $732 billion and $677 billion for fiscal year 2024, respectively.

Although these figures are significantly less than the over $1.6 trillion in net issuance seen in 2023, they remain substantial. This will likely ensure that short-term bills maintain their share of the total marketable debt above the Treasury Borrowing Advisory Committee’s recommended range of 15-20%. Currently, this ratio is around 20.5% and could rise above 22% next year, remaining elevated for a considerable time.

Although a decrease in the percentage of bills outstanding below 20% isn’t anticipated for several years, analysts expect the weighted average maturity of Treasury debt to hold steady around 70 months in 2024.

"Bills as a percentage of outstanding debt will continue to grow due to heightened deficits, unless coupon auction sizes expand beyond our estimates," noted Bank of America’s rates strategy team.

In an optimal scenario, the Treasury would prefer not to depend heavily on short-term financing, as it poses risks associated with rapid interest rate changes or shifts in buyer sentiment.

However, this short-term focus could alleviate pressure on long-term rates and grant the Treasury some leeway before returning to longer maturities when, ideally, yields are lower and the Fed has begun cutting interest rates.

Success in this strategy may hinge on the market’s ability to absorb bill supplies; all else being equal, an unexpected increase in bill issuance could drive rates higher.

Fortunately, robust demand exists. Money market funds, holding about $6 trillion in assets, currently own approximately 27% of all outstanding T-bills, up from around 15% earlier this year. This shift is largely due to funds reallocating from the Fed’s reverse repo facility, which has decreased significantly since June. There remains potential for these funds to increase their holdings, as this percentage was as high as 45% post-COVID.

Despite the anticipated high levels of bill issuance in the coming years, yields above 5% are likely to attract buyers. One firm indicated, "We expect demand to remain strong, driven by attractive yields and the outlook that the Fed is likely done with rate hikes."

(The opinions expressed here are those of the author.)