Treasury's Cut of the Borrowing Plan Surprised the Market. Why Does It Matter?

The US Treasury Department anticipated to procure less net debt from the market, providing a positive indicator for bond traders who are anticipating details on the volume of upcoming longer-term bond auctions.

On Monday, the Treasury revised its borrowing forecast for the first quarter down to $760 billion, a reduction of $55 billion from its previous projection in October. The decrease in the total supply of Treasury bonds instills confidence in traders that the market can accommodate demand, leading to a dip in yields and consequently enhancing the value of bonds held in an investor's portfolio.

This update contributed to a decline in the yield on the 10-year Treasury note, which dropped to 4.075% following the announcement from a level of 4.1% just before the news was released. This was a decrease from the closing yield of 4.143% on the preceding Friday.

Looking ahead to the second quarter, Treasury said it expects to borrow $202 billion in net marketable debt with a cash balance of $750 billion. Borrowing needs are less in the April-June quarter because of the April 15 is when individual income tax returns are due.

Investors are now gearing up for Wednesday's announcement, which will specify the exact sizes of the long-term and medium-term bonds the Treasury intends to issue.

■ Higher fiscal inflows allow the government to borrow less.

This reduction was not unexpected. Fed's weekly TGA (Treasury General Account) stats showed that the Treasury Department currently has relatively abundant cash, and it is not unreasonable to revise down the bond issuance plan.

The fiscal revenues in the first three months of fiscal year 2024 (counted from October of each calendar year) showed that personal income tax and corporate income tax have increased compared with the first three months of fiscal year 2023, although the deficit is still serious.

■ What's the relationship between debt levels and the yields?

From the 1990s to the early 2000s, every 1 percentage point of the ratio of debt to GDP would push the government bond yield to rise by 2.5-3bp. However, since the global financial crisis, the sensitivity of bond yields to debt has fallen by about half, back to the current level of around 1-1.5bp.

Why has debt-yield sensitivity declined significantly over the past 20 years?

Goldman Sachs believes this is because rising global private savings rates have helped buffer the "crowding-out" effect of public debt on private sector investment, thereby reducing the sensitivity of yields to debt levels.

Soaring debt leads to higher yields because public debt "crowds out" private investment, thereby increasing the marginal product of capital (the equilibrium level of interest rates) in the economy. Therefore, when the private sector has more savings, or when investment demand is low relative to savings, the "crowding out" effect of public sector debt is mitigated.

Private sector savings have generally trended upward over the past two decades, with growth particularly strong during the pandemic, resulting in bond yields being less sensitive to public sector debt.

But currently, this savings-investment situation is uncertain. On the one hand, the U.S. savings rate fell sharply after the epidemic, and global savings levels also adjusted downward. In terms of investment, highlighted geopolitics has led to the restructuring of the global trade chain; investment in technology upgrades represented by AI, and investment in energy and green energy transformation may promote a reasonable recovery in the investment rate.

Goldman Sachs believes this will make bond yields more sensitive to public debt. In the long term, the yield-debt sensitivity will also return to the level of the mid-2000s; that is, for every one percentage point increase in the debt-to-GDP ratio, government bond yields will increase by 2-2.5bp. The next ten years will also push up the center of US medium and long-term bond yields to 55-65bp.

■ The term structure of U.S. debt issuance deserves more attention

In fact, the debt pressure caused by the deficit in the United States this year is still very strong, and the deficit will account for more than 6% of nominal GDP. In terms of the term structure, if the proportion of medium and long-term bond issuance increases as expected, once it exceeds what the market can bear, it will still put upward pressure on long-term interest rates in stages.

In late January, the 5-year U.S. Treasury bond auction shocked the market. As the offering size reached US$61 billion, the auction winning rate rose to 4.055%, which was higher than last month's 3.801% and 2bp higher than the advance rate of 4.035%. The bid multiple is also very ugly, hitting the lowest level since September 2022.

The market once repriced the U.S. bond yield curve, with the 30-year Treasury bond yield climbing to nearly 4.42%, its highest level this year. It can be seen that the market's ability to undertake large-scale debt supply is still questionable.

This year, the Treasury Department is unable to adjust the maturity structure and shift long-term supply to short-term supply as it did last year, because a large number of short-term bonds have significantly absorbed market liquidity last year. The scale of overnight reverse repurchase (ON RRP) has rapidly narrowed to approximately US$600 billion. Once the reverse repurchase is further reduced or even cleared, the liquidity squeeze will directly hit bank reserves, thus threatening the liquidity of the financial system.

Currently, primary underwriters hold a large amount of 5 and 10-year treasury bonds, which has reduced the flexibility of their balance sheets, and has become one of the reasons for the recent intensification of fluctuations in interest rates in the repurchase market.

In addition, among the net buyers of government bonds, the two categories that have seen a relatively significant increase are mutual funds and individual investors, including hedge funds, rather than overseas investors who originally accounted for a higher proportion. This will also continue to drain banks' reserves. As a result, the Fed may have to start tapering off its balance sheet before reserves are still above the desired level.

Therefore, how the Treasury Department's financing plan and large treasury bond auctions this year, the Federal Reserve's interest rate cuts, and balance sheet reduction expectations management will be very important factors affecting not only the trend of U.S. bond interest rates, but even financial liquidity conditions.