The U.S. Treasury’s most recent quarterly refunding statement is out and it looks like they are steepening curve. Just as the Fed can influence the shape of the yield curve by adjusting the maturity profile of its asset purchases (see Maturity Extension Program aka Operation Twist where the Fed flattened the yield curve by selling short-dated Treasuries and buying longer dated Treasuries), the Treasury can influence the shape of the yield curve by deciding on where to issue on the curve. In this post we discuss the how supply and demand dynamics can affect the shape of the Treasury curve, and why the Treasury curve can continue to steepen significantly.
Basic Supply and Demand Factors Affect Yields
Putting aside fundamentals, such as expectations for the future path of Fed policy or inflation, Treasury yields are affected by basic supply and demand dynamics. If Treasury issues a lot of debt, then yields will go higher. The Treasury market is the deepest market in the world, but a large enough surge in debt issuance will still need to be digested. Investors may not immediately have enough cash on hand to absorb the issuance, and yields may need to rise to attract investors from other corners of the market.
This dynamic can easily be seen in $300 billion surge in Treasury bill issuance in early 2018, which pushed bill yields as a spread to OIS to widen 20 basis points in a matter of weeks (the Overnight Index Swap is an estimate for the expected path of Fed policy and used here to separate higher bill yields due to expectations for a Fed hike). The Treasury bill market is the most liquid part of the Treasury curve with a very large investor base, including the multi-trillion money market fund complex. However, $300 billion is also a large chunk of debt. Bill yields had to increase to attract money away other short-term investment products like commercial paper and bank CDs.
How the U.S. Treasury is Steepening the Yield Curve
The Treasury seeks to issue debt at a rate that is “regular and predictable,” and at the least expected cost overtime to the tax payer. In practice that means that they set a predictable auction schedule for coupon securities and meet any unforeseen cash needs by issuing Treasury bills (coupons are Treasuries that mature in 2 to 30 years and pay semi-annual coupons, as opposed to Treasury bills which are issued on a discount basis and mature within a year). For example, the unexpected surge in Covid related government spending in 2020 was first met by significant bill issuance in April and then larger coupon issuance sizes in the following months.
The Treasury projects that for the current quarter it will be reducing the amount of bills outstanding by $400 billion and increasing the amount of coupons outstanding by $700 billion (Note that the Fed will also buy around $240b this quarter). The Treasury’s projections do not take into account any stimulus legislation, so the projections may change if further fiscal stimulus is announced. But as it stands the Treasury is effectively steepening the curve. Decreasing the supply of Bills lowers short-term rates, while increasing the supply of longer dated coupons raises longer-term rates.
Yields Are Set to Move Higher (Until the Fed Steps in)
The Treasury is prudently managing their debt by taking advantage of historically low long-term rates, and a Fed that is actively buying. Since longer term rates are low, it makes sense to issue more longer dated debt. The Treasury behaved the same way the last time QE was in full force. But the level of issuance this time is unprecedented, and is currently projected to be $2.5 trillion in coupons this year and the next. Back in early 2020 a $1 trillion in net issuance would be a large number, but now the Treasury is consistently issuing over $2 trillion. Even with the Fed’s buying $80 billion a month this still a sizable amount over a short period of time.
The Fed would never allow yields to go too high and it has absolute control over the yield curve. Note that central banks around the world have been able to effectively engage in “yield curve control” and pin certain parts of their yield curve (See Japan pinning their 10-year and Australia pinning their 3-year). But with U.S. 10-year real yields bouncing around historic lows of -1%, it seems that there is still room for the market to move yields higher before the Fed would step in. This is especially true if higher yields are accompanied with a narrative of higher economic growth. With short dated rates anchored by both the Fed and the large level of cash in the system, higher longer dated yields imply that the curve should continue to steepen.