Clarity sought on U.S. ultra-long bonds from Treasury funding update

The U.S. Treasury building is seen in Washington
The U.S. Treasury building is seen in Washington, September 29, 2008. REUTERS/Jim Bourg

August 1, 2017

By Karen Brettell

NEW YORK (Reuters) – The government’s refunding schedule wildcard on Wednesday will be if the U.S. Treasury Department gives any indications on whether it will issue a longer-dated debt maturity.

The Treasury said in May it was considering issuing an ultra-long bond, with a maturity of 50-years seen as most likely, or reviving a 20-year issue that was abandoned in 1986.

An ultra-long bond would fit in with the Treasury’s objective to fund the U.S. government at the lowest cost over time.

“The big event this week is the refunding on Wednesday,” said Blake Gwinn, an interest rate strategist at NatWest Markets in Stamford, Connecticut. “You could potentially get some move forward on a commitment to ultra-long issuance, or at least some further guidance on what they’re thinking there.”

Plans to increase longer-dated debt would likely send thirty-year bond yields higher and steepen the U.S. yield curve.

Depending on the size of the issuance, a sufficient amount of ultra-long bonds could also lengthen the average maturity of the U.S. government’s marketable securities, said Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York.

The average maturity of U.S. government debt at the end of June was a record 71 months, up from 49 months at the end of 2008.

Market participants will also be watching for information on how the government plans to increase debt issuance to make up for the Federal Reserve’s declining bond purchases.

A Reuters poll of primary dealers last week showed that Wall Street’s top banks expect the Fed to announce a date when it will kick off the reduction of its $4.5 trillion balance sheet after its meeting on Sept. 19-20.

The refunding announcement will be made on Wednesday at 8:30 a.m. EDT (1230 GMT).

FED PARTICIPATION TO DECLINE

The Fed buys debt in addition to that offered in U.S. Treasury auctions, and as it backs away, the government will need to increase debt sales to the public to make up the difference.

Analysts expect – at least initially – the Treasury will issue shorter-term debt to make up for declining Fed participation, which should be readily absorbed.

Money fund reforms have increased inflows into funds that only invest in Treasury bills, which gives the government room to boost bill issuance without market disruption.

“There is a ton of capacity to issue bills,” said Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets in New York. “And in that case there’s not a lot of duration flowing into the market, so it will have very little market impact.

The Fed has said it will take a slow approach to tapering purchases, setting the initial cap for the reduction of Treasury holdings at $6 billion per month and raising it in $6 billion increments every three months over a 12—month period until it reaches $30 billion per month.

The Treasury in recent years has cut public auction sizes of short- and intermediate-dated coupon debt, which gives it room to ramp them back up to make up for the Fed’s declining participation.

(To see changes in U.S. Treasury auction sizes since 2008, click: http://reut.rs/2hlsF4m)

The government’s debt issuance will be restricted in the coming quarter as it bumps up against the debt ceiling. The Congressional Budget Office has said U.S. lawmakers need to raise the debt ceiling by mid-October to avoid defaulting on debt payments.

The Treasury said on Monday that it expects to borrow $96 billion in the third quarter, but that is expected to swell to $501 billion in the fourth quarter as the government replenishes its cash levels in the aftermath of the expected debt ceiling standoff.

Longer-term, the Treasury will face rising cash needs from an aging population and as the Fed accelerates its balance sheet reduction, with financing needs expected to jump in the second half of 2018.

That will mean that the government will have to increase longer-dated debt sales to make up the difference.

“Over time they are going to have to issue further out the curve,” said Subadra Rajappa, head of U.S. interest rate strategy at Societe Generale in New York. “They have to issue more because of the Fed reinvestments and because the (budget) deficits are poised to rise regardless.”

If a new debt issue is on the cards, it would make sense to announce it at this week’s refunding. That would give the market time to prepare for its introduction and have initial test sales before the bonds are needed, said NatWest’s Gwinn.

“The funding gap really starts to grow in late 2018, but you don’t want to wait until that happens to start issuing for it,” Gwinn said. “You want to roll that out in a calm market, when you are not jacking up the auction sizes along the rest of the curve.”

(Reporting by Karen Brettell, editing by G Crosse)