Changes in Treasury Issuance Favor Bear Flattening

Bloomberg – U.S. Raises Longer-Term Debt Sales as Budget Deficit Worsens
It raises size of 3-, 10- and 30-year debt sales next week
Mnuchin’s debt management team will sell next week $26 billion of 3-year notes versus $24 billion in November, it said Wednesday in its refunding announcement. The department also lifted to $24 billion the sale of 10-year notes from $23 billion and 30-year bonds to $16 billion from $15 billion, also to be auctioned next week. Total offerings rose to $66 billion from $62 billion in November. The Treasury said it expects to lift sales of 2- and 3-year note auctions by $2 billion per month over the quarter. It will also boost 5-, 7- and 10-year notes and 30-year bond auction by $1 billion each month starting in February. Sale of 2-year floating-rate notes will also be increased by $2 billion beginning next month. Additional borrowing needs will be addressed by increasing bill sales. The emphasis on boosting two- and three-year maturities is a short-term financing solution and means the Treasury will probably need to keep increasing auction sizes going forward, Stephen Stanley, chief economist at Amherst Pierpont Securities LLC, said in a note.
Financial Times – Treasury halts attempts to extend maturity of US debt in refunding plan
“In total, these adjustments will result in an additional $42bn of new issuance for the upcoming quarter . . . As stated at the November quarterly refunding, Treasury anticipates these changes will stabilise the weighted-average maturity (WAM) of the debt outstanding at or around current levels, notwithstanding large, unexpected changes to borrowing needs,” said Clay Berry, deputy assistant secretary for capital markets at the US Treasury, in a statement.
Washington Post – Federal government will be unable to pay all bills sooner than expected, due to new tax law
The debt ceiling had been suspended until Dec. 8, 2017, and the Treasury Department has taken emergency steps since then to delay falling behind on payments. But it can only use those measures for a short period of time, and CBO said Wednesday that this window is narrower than it previously thought. Lawmakers are already facing a government shutdown deadline Feb. 8 and are struggling to cut a deal on immigration before work permits for young immigrants brought to the United States illegally as children begin to expire in early March. The timelines for all these must-do tasks are beginning to converge, raising the possibility of one enormous deal in coming weeks wrapping all the issues up. For now, though, solutions look remote.

Summary

Secretary Mnuchin and the Department of the Treasury released the details of the quarterly refunding along with the specific implementation of changes to auction sizes. Much of the increase in new issuance will be focused on the belly of the curve. This will be a persistent bear flattening influence for the Treasury curve.

Comment

The challenge the Department of the Treasury faces is a surge in borrowing needs from higher spending, tax cuts and the tapering of proceeds reinvestment from the Fed’s SOMA portfolio. Projected new issuance is expected to roughly double from 2017’s figure of $537 billion. As we discussed on January 10, the Treasury has conducted an analysis on the optimal way to increase issuance along the curve.

As we laid out in detail in our January 10 post, the analysis found that allocating most of the new issuance to the belly of the Treasury curve and Treasury bills minimized risk. It’s important to note that the Treasury Borrowing Advisory Committee’s stated goal is to minimize the variability of debt service and fiscal deficits, not simply to minimize the cost of debt service.

The chart below, from the addendum to the November quarterly refunding report, shows current (left) and optimal (center) issuance mixes. The far right panel shows the difference, optimal – actual.

The optimal issuance profile favors much higher weights for the belly, with over 60% of issuance in 2-year, 3-year, and 5-year notes. The optimal mix also favors less than 25% of issuance in bills and a very modest decrease in long-end issuance.

Wednesday’s announcement moved in that direction, but did so fairly conservatively with regard to Treasury bills and long-end issuance. Below is the statement from the TBAC Report:

Specifically, increased issuance should favor T-bills and the belly of the curve—recalling that the “belly” is defined as 2s, 3s, and 5s—along with longer-term issuance. While the WAM is just an outcome of an issuance strategy and not a goal in and of itself, it was noted that there was no particular bias to change the WAM going forward. Rather, an issuance strategy that’s skewed to favor the belly of the curve would keep the WAM roughly around its current value, give or take a few months.

The Treasury provided estimated auction sizes through the second quarter of 2018. A total of $42 billion in new issuance is expected in the first quarter.

Near term, Treasury bill issuance will be disrupted by the debt ceiling debate that faces its next hurdle on February 8. Bill auction sizes will then increase substantially in March. The refunding announcement directly addressed the need to pass a solution.
Auction sizes for 2-year, 3-year and 5-year notes will increase by $2 billion a month through the first quarter, then $1 billion a month through the 2nd quarter. The 2-year floating rate note auction will grow by $1 billion in April and May.
Auction sizes for 7-year and 10-year notes and 30-year bonds will increase by $1 billion each month through the second quarter.
TIPS issuance is expected to increase along with nominal issuance, with growth in issuance tilted toward the 5-year maturity.

On January 8 we looked at how the composition of issuance was more important to the shape of the Treasury curve than the overall size of new issuance. The chart below is a variation of the version from that post. The x-axis shows 12-month changes in the percent of total issuance for each maturity as a z-score. The y-axis shows the effect each change has on the estimate of the 2y10y spread.

Larger increases in issuance in bills and the 2-5 year maturity range are bear-flattening friendly. The increase in longer maturity issuance will offset some of that bear-flattening influence by pushing long-end yields higher. On net, the changes in issuance will be bear flattening. This may be compounded in the near term by the market-adjusted expectations toward a hawkish Fed.

Conclusion

The Treasury took the first step toward addressing rapidly growing funding needs. Mostly as expected, the Treasury has decided to focus the growth in new issuance in bills and the 2-year to 5-year range of maturities. Somewhat surprisingly, they will also boost longer maturity auction sizes, but at a slower pace. More changes in the second half are likely as these were not sufficient to address the total growth in funding needs. The net effect is a bear-flattening influence for the Treasury curve as auction sizes continue to growth through the year.