By Adam Marden, Portfolio Manager, Multi-Asset and Fixed Income at T. Rowe Price
The U.S. government will need to issue more Treasury debt to fund its package of tax cut extensions and new spending cuts. Combined with new outlays on defense and immigration enforcement, the Congressional Budget Office estimates that the tax breaks and spending will boost the budget deficit by more than $3 trillion USD over the next 10 years (excluding the effects of any tariff revenue). While we anticipate that money markets will be able to absorb the initial flood of new Treasury bill supply, the U.S. Treasury’s eventual move to issue more notes and bonds will pressure longer-term yields higher.
Here we outline the four key impacts of the fiscal expansion for fixed income markets over the coming months:
- Growth in Treasury bill supply
- Money markets able to digest new supply
- Long-term shift to coupon issuance
- Bank deregulation to marginally support Treasury liquidity
Large and immediate increase in Treasury bill supply
Treasury Secretary Scott Bessent has stated that the Treasury Department will initially issue most of the new supply in the bill market as opposed to coupons.[1] This would take advantage of the low yields on short-maturity debt relative to long-maturity debt and help restrain the government’s total interest costs.
The balance in the Treasury general account (TGA)—which functions like the government’s checking account—has been running down after the April tax payment inflows, so there will be a large and immediate increase in the bill supply to refill the TGA. Currently, 20% of the overall U.S. Treasury debt stack is in bills as opposed to coupons. We anticipate that this will increase to the 23%–25% range when the government boosts bill issuance to fund the fiscal package.[2]
However, the Treasury Borrowing Advisory Committee (TBAC), a group of market participants that provides guidance to the Treasury Department on debt issuance, has warned that a higher bill share increases deficit variability. TBAC has historically guided the Treasury Department to an average of around 20% of U.S. Treasury marketable debt in the form of bills.
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The peak percentage of bills in the total Treasury debt stack was nearly 35% in November 2008, when relatively high longer-term yields encouraged the Treasury to keep as much of its debt as possible in short-maturity instruments. The proportion of bills reached a recent low of 10% in October 2015 as the Treasury took advantage of near-zero long-term rates to lock in attractive financing for years.
Money markets look able to digest new Treasury bill supply
Will money markets be able to absorb the meaningful level of new supply without forcing short-term rates higher? The short answer is yes. The weighted average maturity (WAM)[3] limit for money market funds is 60 days. As of June 30, money market funds had an average WAM of 38 days,[4] indicating that they have room to buy newly issued, somewhat longer-maturity Treasury bills (although they will want to receive enough incremental yield to justify moving into longer-dated bills). We don’t anticipate any plumbing problems from lack of liquidity causing short-term funding rates to spike along the lines of the scenarios in September 2019 and at the onset of the pandemic in 2020.
While we don’t anticipate problems in the short-term funding markets, we continue to monitor indicators that would signal impending distress. These include primary dealer[5] holdings as a percentage of all bank reserves—a higher level indicates that buyers for newly issued Treasury bills are not emerging, leaving the securities on dealer balance sheets for longer. Also, an uptick in the use of the Fed’s standing repo facility and other backstop lending facilities, or an increased demand for Federal Home Loan Bank (FHLB) funding, would be signs of stress in financial market plumbing.
Issuance to eventually shift to coupons
But after the rush of initial Treasury bill issuance, the Treasury will reach its target proportion of bills and turn to the coupon market for new debt issuance, although the timing of the switch is uncertain. The medium- and long-maturity Treasury market has already been jittery with more limited liquidity than usual, as evidenced, in particular, by the rapid increase in yields following President Trump’s April 2 tariff announcement. A major increase in coupon supply amid heightened worries about the U.S. government’s overall debt level creates the conditions for a sustained yield increase in 10- and 30-year Treasury securities.
Bank deregulation movement could help liquidity in Treasuries
The Trump administration has kicked off a trend toward financial sector deregulation, some of which could enhance liquidity in the Treasury market and help smooth out the transition to additional coupon supply. One set of regulatory capital requirements constraining some large banks includes leverage-based capital requirements.
In particular, the supplemental leverage ratio (SLR) that applies to the largest U.S. banks—which are also important market makers for Treasury debt—has restricted these banks’ trading in Treasuries by requiring them to maintain the same level of capital in proportion to their Treasury holdings as to their holdings of riskier securities. This has made them less willing to keep Treasuries available for purchase or sale on their balance sheets, dampening market liquidity and likely pushing yields higher. For instance, academic research has found a link between dealer balance sheet capacity utilization and the otherwise unexplained volatility experienced in March 2020.[6]
In late June, the Fed announced a proposal to reduce the amount of capital that banks need to hold in proportion to all assets. While this would still subject holdings of Treasuries to the same requirements as riskier assets, it would likely make banks more willing to help smooth Treasury trading in times of market stress.
Although it may not strictly fit into the deregulation category, the recently enacted GENIUS Act could help reinforce demand for Treasury bills. The legislation is designed to make stablecoins[7] a trusted medium of exchange by requiring some of the reserves backing them to be invested in Treasury bills. However, it’s unclear how much this would support demand for Treasury bills.
While these changes in financial regulation could help improve Treasury market liquidity when sentiment aggressively shifts to risk-off mode, deregulation is proceeding too slowly and doesn’t go far enough to offset the upcoming boom in supply—and the heightened Treasury issuance over the last five years. This dynamic is likely to lead to higher longer-maturity yields. Investors should be aware that the flood of new Treasury supply could make longer-term Treasuries less effective as a portfolio diversification tool in major risk-off episodes.
[1]Bills have a maturity of 1 year or less and sell at a discount from face value, so the holder’s interest is the form of the difference between purchase price and principal at maturity. “Coupons” have a maturity of more than 1 year and pay interest in the form of coupon payments.
[2]T. Rowe Price estimate. Actual outcomes may vary significantly.
[3]WAM is the time to maturity of each debt instrument in a money market fund weighted by the percentage of the portfolio that each security accounts for.
[4]Source: Crane Data.
[5]Primary dealers buy newly issued securities from the Treasury and can transact directly with the Federal Reserve.
[6] https://www.kansascityfed.org/Jackson%20Hole/documents/9726/JH_Paper_Duffie.pdf
[7]Stablecoins are a cryptocurrency whose value is linked, or pegged, to another asset or a currency such as the U.S. dollar.
