The battered Treasury market must now account for supply changes

(Bloomberg) – The Treasury market faces a series of supply-side cross-currents that could complicate the trajectory of yields as they rise.

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This price will be supported by the latest reduction in purchases of US government bonds by the Federal Reserve, which will only buy $ 40 billion of Treasuries over the next month, half the amount they have gobbled up. in the past. For the first time since the launch of the last so-called quantitative easing program in March 2020, they will no longer occur on a daily basis. At the same time, dealers will be busy estimating how much the Treasury Department will reduce the size of its auctions when it announces its quarterly sales plans.

Yields on US debt maturing over the next decade have climbed over the past two weeks to levels seen before the pandemic rocked global markets in early 2020, with the benchmark note rate at 10 years having climbed more than 25 basis points this year. This change reflects growing expectations that the Fed will raise overnight interest rates at least three times this year, if not four times, and also that it will eventually stop replacing the Treasuries it holds when they will expire. A decision on that may not come until March, however, when programming adding new assets to the balance sheet is expected to end.

Increasing the rate at which the Fed slows its bond purchases “is akin to loosening the nuts on the training wheels and the bike will be a little more wobbly for the market,” said William O’Donnell, strategist at Citi. “In March, the training wheels come off. The question is how much of the Fed buying less Treasuries is already priced in by the market given the rise in yields we’ve seen so far this year.

The Fed’s latest reduced buying schedule includes 10 operations from January 18 to February 10. Previous monthly calendars had 18 trades, usually one per trading day.

The purchases, which have added $3.12 trillion of Treasuries to the Fed’s stock since March 2020, have left a massive footprint. Initially undertaken to restore liquidity – which briefly disappeared when the onset of the pandemic led to massive dumping of financial assets – the purchases continued as a way to further support the US economy after the Fed has been reduced to around zero.

Although all purchases are made on a pre-announced schedule, his decisions on how to spread his purchases across the range of timeframes have moved the market several times. The prospect of less Fed buying leaves Treasury dealers more completely at the mercy of investors.

“Overall, we can expect more volatile coupon auctions as there will effectively be more supply for the market to buy,” O’Donnell said.

The 10-year rate ended Friday at 1.78%, marking its fourth consecutive weekly rise. Treasuries have lost 1.8% so far this year, on top of a 2.3% loss last year, the first annual decline since 2013, based on the Bloomberg Treasury Index .

Morgan Stanley strategists expect the 10-year Treasury yield to rise to 2.2% in the second quarter and end the year at 2.3%. They predict that the Fed will raise rates by 25 basis points each quarter. Money market traders, who as recently as June expected the Fed to keep rates unchanged through the end of this year, now assign nearly 100% probability to hikes beginning in March. While Fed officials forecast an average of three rate hikes in December this year, several this month said a March hike was needed to tackle the highest inflation in a generation.

Meanwhile, the Treasury Department, which cut the size of coupon debt auctions in November for the first time in five years to align them with weaker-than-expected government spending, is expected to do so again in February, regardless of the Fed’s plans. But on Friday, its quarterly survey of primary traders asked for their views on how a Fed decision to allow its holdings to be liquidated might affect “funding needs and issuance decisions.”

The prospect of the Fed allowing some of its Treasury holdings to mature likely won’t prevent auction size cuts in February, but it does make later cuts less likely, said Lou Crandall, chief economist at Wrightson ICAP. LLC.

“As we move forward this year, we probably won’t know the future, but if things develop as expected, we will normalize policy,” Fed Chairman Jerome Powell told the Senate Banking Committee on Tuesday. during an interrogation during its confirmation. audition for a second term as head of the central bank. “That means we’re going to end our asset purchases in March, we’ll raise rates over the course of the year, and at some point – maybe later this year – we’ll start letting the balance sheet sink. ”

The Fed’s next two-day meeting will end on January 26. With interest rate strategists expecting a decision on winding up balance sheets in June at the earliest, the messages could start sooner.

“Investors are debating what the Fed will tell us at the end of the month,” said Matthew Hornbach, global head of macro strategy at Morgan Stanley. “Most investors watching Treasuries will err on the side of caution until after the Fed’s January meeting.”

What to watch

  • US financial markets will be closed on January 17, Martin Luther King Jr. Day.

  • Economic calendar:

    • January 18: Manufacture Empire; NAHB housing index; International Treasury Capital Flows

    • January 19: MBA mortgage applications; construction starts and building permits

    • January 20: Unemployment insurance claims; Philadelphia Fed Trade Outlook: Existing Home Sales

    • January 21: leading index

  • Fed officials have no appearances scheduled during their self-imposed period of calm until the Federal Open Market Committee meeting on Jan. 25-26.

  • Auction schedule:

    • January 18: 13 and 26 week invoices

    • January 19: reopening of 20-year bonds

    • January 20: 4, 8 week invoices; ADVICE 10 years

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