Eric Leininger, CME Group
IN ONE LOOK
- As the Federal Reserve shrinks its balance sheet, the supply of US Treasuries could allow other entities to expand their own positions
- On its current path, the US Treasury will issue $23 billion less in securities per month, leaving about $146 billion in net new duration issuance before the end of 2022
The U.S. Treasury market could see more buyers increase over the remainder of this year and into 2023 to offset lower Federal Reserve buying activity.
Even though the Treasury will issue fewer bonds during this period, the decline in supply does not offset the decline in demand from the Fed. This means that the US rates market will only clear if there is increased buying by other entities, including the private sector.
The Fed recently announced that it would seek to reduce their purchases by up to $522.5 billion in 2022 and $1.14 trillion in 2023. As the Fed shrinks its balance sheet, other entities will see the available supply of US Treasuries increase, allowing them to expand their own positions.
The implications of the change in Fed and Treasury policy are only just beginning to become clear. Besides the greater reliance on non-Fed buyers, another important development is that the supply of government bonds will rise further down the curve relative to faster issuance.
Another development is that the changing market profile could also have a significant impact on derivatives markets: as the broader interest rate market has to absorb more bonds, the potential hedging needs could be huge.
Treasury issues, although down slightly, remain very high from a historical point of view.
In the context of the 2002-2021 period, the current level of debt issuance remains huge. In recent years, Fed buying has helped digest these elevated levels. Now, however, the Fed is significantly capping the purchases it will make from principal repayments.
The reduction in the Treasury’s redemption will be felt primarily in shorter-dated rather than long-dated bonds, although the midpoint of the curve – the 7-year bond – will see the biggest drop in issuance.
In comparison, the long term – including 10, 20 and 30-year bonds – will see only a slight reduction.
The US Treasury typically targets a five-year duration profile for its issuances, but in recent years it has issued securities with a much longer duration.
The Treasury’s objective has been to actively lengthen the duration of its typical bonds in order to take advantage of the recent low rate environment. Earlier this year, the Treasury reported that its debt-weighted average maturity had risen to around six years, while the latest quarterly repayment schedule implies a term of just over eight years.
When we add the probable Treasury issues with the potential mortgage requirements, the market can look at up to $146 billion in six-year terms from Treasury bills and $192.5 billion from a term of five years on the mortgage side.
By increasing the notional of the Treasury for a duration equivalent to five years by multiplying it by 6/5, the total duration increases to 175 billion dollars. This suggests that around $368 billion with a five-year term will hit the market from June to December.
This figure could be lower if we see slightly less Treasury issuance and less mortgage production, but any rate hikes or more issuance would increase duration. A reasonable range of duration is $350 billion to $400 billion in 5-year notes.
Such large sums imply an equally large demand for coverage. In terms of derivatives, this level of issuance would equate to 3.5 to 4 million more 5-Year Treasury Bill Futures Contract contracts.
Current 5-year note futures are averaging a daily trading level of around 1.6 million contracts.
The need for increased hedging in 5-year futures is likely to last for a long time, as oversized issues around the five-year term are expected to continue hitting the market for at least the next two years.
Much of this activity will begin from June as the market currently expects the Fed to raise interest rates another 50 basis points. Managing and hedging all this increased duration could potentially keep the interest rate market extremely busy this summer and beyond.
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