US to test investor appetite with deluge of long-term Treasury sales

The US is set to flood the market with long-term bonds next year, raising questions over who will buy the debt and at what price.

The Treasury department plans to sharply shift its bond sales towards debt maturing well into the future as the government seeks to fund vast spending programmes.

Investors will be left to gobble up $1.8tn in Treasuries with maturities of greater than one year even after accounting for the Federal Reserve’s massive bond-buying programme, according to estimates by JPMorgan. This will mark a stark contrast to this year, when a far greater proportion of the Treasury’s issuance was in shorter-term debt.

With expectations for higher growth and inflation in 2021, strategists say the US may be forced to offer higher interest rates on these longer-dated securities to entice investors to purchase the debt.

“When we add the numbers up, we have a pretty big demand gap,” warns Jay Barry, a managing director on the interest rate strategy team at JPMorgan. “We think a modest rise in yields will be necessary to encourage demand.”

Treasuries serve as a key benchmark for other types of debt, meaning a rise in US government borrowing costs could cascade across the broader fixed-income landscape. Higher yields also represent one of the main risks for the equities market, analysts have said.

The deluge of long-term Treasury sales comes at a time when investors have already gravitated towards higher-yielding, riskier corners of financial markets in anticipation of a robust economic rebound next year and as the Fed continues taking actions to keep financial conditions loose.

US government bond prices have fallen, as a result, sending yields close to their highest levels in nine months. Longer-dated Treasuries have borne the brunt of the sell-off, with yields on the 10-year Treasury note climbing from below 0.7 per cent at the start of October to just under 1 per cent. 

The odds of a dramatic spike in borrowing costs is low, analysts and investors say. The Treasury has already funded the $900bn stimulus package signed into law by President Trump this week, according to Jefferies, and is currently sitting on a record cash pile of $1.5tn. Issuance of shorter-term debt, known as bills, is expected to decline next year as well, several fixed income strategists said.

But investors reckon the “supply overhang” in long-dated Treasuries — as Subadra Rajappa, head of US rates strategy at Société Générale, describes it — coupled with the spectre of resurgent growth and inflation will push Treasury prices even lower next year. Ms Rajappa forecasts 10-year yields will rise as high as 1.5 per cent.

Line chart of % of marketable Treasury debt showing Foreign holdings of US Treasuries has slid to a 20-year low

Expectations for higher yields stem in part from the Fed’s reluctance to expand its footprint in the market for US government debt.

Ahead of its most recent meeting on monetary policy, a cohort on Wall Street bankers and economists had called on the Fed to shift the bulk of its bond-buying programme to longer-dated Treasuries in order to ensure that financial conditions remain easy despite the enormous issuance slated for next year. It held off, leaving investors to mop up the additional supply. 

Foreign buyers are set to absorb some of it, despite playing a much smaller role in the market in recent years. At 35 per cent, their ownership of Treasury debt is at its lowest level in nearly 20 years, Fed data show. A chunk of the buying is likely to come from Japanese investors given that their domestic government debt holdings are guaranteed to make a loss if held to maturity, said Olivia Lima, a rates strategist at Bank of America.

Banks are also expected to follow up a record year of Treasury demand with another burst of buying. Mr Barry forecasts $200bn for 2021, with an additional $175bn coming from pension funds and insurance companies. That still leaves a $644bn shortfall, according to Mr Barry’s calculations based on overall Treasury issuance, even once other sources of demand are factored in.

Given this gap, Kathy Jones, chief fixed-income strategist at Charles Schwab, said the Treasury department will need to pay up to sell its long-dated debt. 

“The demand will be there,” she said. “It just depends on how it gets priced.”

Line chart of $tn showing Fed balance sheet booms as central bank looks to prop up economy

Two run-off elections in Georgia could further exacerbate the imbalance between Treasury supply and demand. If Democrats are able to win both races in January and clinch control of the Senate, more aggressive spending packages — and therefore heftier issuance — could be in the offing next year.

Goldman Sachs, which advocates for so-called “curve steepener” bets that profit if long-term yields rise faster than short-term ones, called the elections “the next major source of event risk for the rates market”. 

A move too far, too fast in long-dated Treasury yields that is driven more by supply and demand issues rather than the prospects of faster growth will not go unnoticed by the Fed.

The central bank may need to twist its bond buying towards longer-dated debt or even increase the scale of its bond-buying programme “if the markets start struggling to take down the supply in the first half of year”, said Blake Gwinn, head of short-term rates strategy at NatWest Markets.

That would put an end to any Treasury sell-off, added Oliver Brennan, a senior macro strategist at TS Lombard. “How the Fed decides to structure its demand is going to have the single biggest impact on the market.”

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