Households to Fund US Government Profligacy

Summary

• Net marketable Treasury issuance is likely to remain over $1tn during FY2023-24.
• The Federal Reserve (Fed)’s quantitative tightening (QT) need not be negative for government funding, if it is accompanied by Money Market Fund (MMF) substituting T-Bills to the Fed’s Reverse Repurchase Agreement (RRP), though this could support curve steepening.
• Foreigners are unlikely to increase their Treasury holdings, unless the curve disinverts, which is unlikely anytime soon. 
• US households will remain the most important source of government funding.

Market Implications

• US yields are unlikely to be impacted by concerns over excess supply and government creditworthiness but will instead reflect market views of the business cycle.
• See Mustafa Chowdhury’s Global Rates Weekly: 1-Year Tenor Receiver Swaptions Position Well for Fed Pause.

Fiscal Profligacy Bills Coming Due

On 31 July, the US Treasury Quarterly Refunding announcement surprised markets by showing a $274bn increase in debt issuance in Q3. In this note, I contextualise the announcement and locate where the additional funding could come from.

Fiscal consolidation peaked in July 2022, when the LTM (Last Twelve Months) budget deficit troughed at 4.5% of GDP (Chart 1). Since then, the budget deficit has increased to 8.5% of GDP over the year to July 2017. The budget deficit will fall due to the Supreme Court cancellation of the Biden administration’s debt forgiveness plan but is still expected by the CBO to reach about 6.5% of GDP for the whole of FY2023 (ending in September 2023).

The assumptions I have used to build Chart 1 are:

Budget deficit (Table 1): 

• The CBO expects the FY2023 deficit to be $1700bn or 6.5% of GDP, including the impact of student loans and repayment plans.
• Student loans: the Supreme Court cancellation is expected to lower August or September expenditures by $330bn. This will impact Treasury issuance little since, under US budgeting rules, the whole cost of the measure was recorded upfront, rather than on an accrual basis. At the same time, the administration’s new income-driven repayment plan and discharge rules increased July spending by $91bn.
• FY2024 is an election year. With the same party controlling the White House and the Senate, I am not expecting fiscal consolidation. I have therefore assumed the same deficit-to-GDP as in FY2023.

Issuance:

• Net issuance of marketable debt tends to track the deficit and changes in the TGA (Chart 1).
• Q3 and Q4 2023 issuance and TGA balance per the Treasury’s latest refunding documents.
• No increase in the TGA beyond the $750bn by end Q4 2023.
• Treasury targets 20% ratio of Bills to total marketable debt.

The bottom line is that with this and the next fiscal year’s likely ultra-loose fiscal policy, net issuance of marketable debt is likely to remain above $2tn in both years. This begs the question, who will buy?

Fed Could Continue QT  

I now discuss prospects for Treasury demand across key macroeconomic sectors, starting with the Fed.

As of 3 August, Fed holdings of Treasury debt were $5tn, down from $5.8tn in May 2022. The Fed is likely to keep going with QT until reserves fall significantly below 14% of banks’ assets. 

Reserves have been stable at around 14% of banks’ assets since Q3 2022, as most of the roll off of the bond portfolio is offset by a decline in the RRP rather than in reserves, and banks’ assets have stopped growing.

The Fed, therefore, could keep going with QT for some time. Under the Fed QT plans, it could let up to $60bn in Treasury securities roll off its balance sheet monthly. I estimate that over the next 12 months, the Fed could reduce its Treasury holdings by $600bn.

However, this needs not be negative for government funding.

MMFs to the Rescue?

By contrast with the Fed, pension funds and insurers are increasing their holdings of Treasury debt (Chart 4). And MMF Treasury holdings, which had fallen sharply after Q1 2021, when MMF increased their use of the Fed RRP, have started to stabilize.

The latest data shows that MMF increased their Treasury holdings debt by $330bn in June 2023 alone. 

The Fed’s QT, therefore, will not be negative for government funding if it is accompanied by MMF substituting government debt to the Fed RRP. However, the maturity of the debt released by the Fed is significantly higher than that bought by MMF, typically Bills, which supports curve steepening.

Foreigners Shun Treasuries

Meanwhile, Chart 2 shows foreigners’ Treasury holdings have barely increased since 2020. This reflects two factors.

First global FX reserves and therefore foreign official demand for Treasuries, have not increased since 2021 (Chart 5). An increase in global FX reserves could be needed to get foreign officials to add to their Treasury holdings. In turn, this would require marked dollar strength, which we do not expect.

At the same time, private foreign Treasury holdings have not increased since 2011, when the curve inverted and the carry-on hedged Treasury holdings turned negative. Private foreign interest in Treasury debt may not revive until the curve fully disinverts, which we do not expect soon.

US Households to Fund Government Profligacy

Unlike the rest of the world and the domestic financial sector, the domestic non-financial sector has greatly increased its holdings of Treasury debt. Within the sector, the increase is most noticeable with households (Chart 6).

This likely reflects the higher yields offered by Treasuries. Households, like insurers and pension funds, have been starved of yield since the GFC and are happy to buy bonds that finally offer a significant return. In addition, the recent equity rally has compressed the equity risk premium, which adds to the attractiveness of 4-5% bond yields.

Household bond holdings represent only 2% of their total financial assets, against a peak at 3.5% in the mid-1990s (Chart 7). This suggests room for further increase from current holdings of $2tn.

Market Consequences

The above data suggests US fiscal profligacy is unlikely to be curbed by funding difficulties. I think the bond vigilantes are unlikely to make a comeback anytime soon, largely because the US bond market still offers a better combination of yields, liquidity, and economic and political fundamentals than its competitors. This suggests that US yields are more likely to reflect market views of the business cycle than concerns over the sovereign balance sheet. Please see Mustafa’s trade idea (Global Rates Weekly: 1-Year Tenor Receiver Swaptions Position Well for Fed Pause).

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)