COVID | Monetary Policy & Inflation | Rates | US
Despite the extraordinary US budget deficit, a very dovish Fed and depressed private investment suggest the Treasury could term out some of its recent issuance with only a limited impact on yields. But, once competition for funding resumes, upside risks to yields could be substantial, especially if accelerating inflation limits the scope for Fed purchases.
The Extraordinary US Budget Deficit
Based on CBO estimates of the COVID-19 relief bills’ deficit impact, as well as on my own estimates of the impact of the pandemic on automatic stabilizers and of the forthcoming relief bill, the FY2020 budget deficit could reach about $4tn or 20% of GDP (Chart 1).
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Despite the extraordinary US budget deficit, a very dovish Fed and depressed private investment suggest the Treasury could term out some of its recent issuance with only a limited impact on yields. But, once competition for funding resumes, upside risks to yields could be substantial, especially if accelerating inflation limits the scope for Fed purchases.
The Extraordinary US Budget Deficit
Based on CBO estimates of the COVID-19 relief bills’ deficit impact, as well as on my own estimates of the impact of the pandemic on automatic stabilizers and of the forthcoming relief bill, the FY2020 budget deficit could reach about $4tn or 20% of GDP (Chart 1).
Treasury Funding Needs and Issuance
In the 4 May quarterly refunding, the Treasury raised the target for the end of quarter Treasury General Account (TGA, the Treasury deposit at the Fed) balance to $800bn, from previously $400 bn, likely in order to provide the Treasury with a liquidity cushion should market volatility disrupt its funding. In any event, the TGA rose to $1.7tn as of 15 July likely due to later than expected outlays of COVID-19 relief as well as the building up of liquidity to be released ahead of the November elections.
With more certainty on its H2 funding needs, the Treasury will probably let the TGA run off to the target of $800bn, though gradually in order to limit reserves volatility (increased Treasury outlays increase reserves). Based on continued market stability, I am assuming that by end-CY2020 the Treasury will have reduced the TGA to $1tn (Table 2).
Treasury Likely to Term Out Its Debt
Most of the debt that the Treasury has issued since the pandemic has consisted of bills, which likely reflect concerns that large Treasury issuance would have further added to the March-April volatility at the long end of the curve. As a result, the share of bills in outstanding marketable debt has increased sharply. With markets back to normal functioning, the Treasury is likely to move back closer to the maturity structure that prevailed before the pandemic.
Fed Likely to Accommodate TGA Runoff
The Fed’s extreme dovishness suggests it will not attempt to sterilize the TGA runoff. At the 10 June press conference, Chair Powell said ‘we’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.’ Since then, Fed speakers have continued with the same message. On 14 July, Governor Brainard stated, ‘As we move to the next phase of monetary policy, we will be guided by our evolving understanding of the key longer-run features of the economy, so as to avoid the premature withdrawal of necessary support.’
Furthermore, the Fed has given no hint that it intends to slow its asset purchases from the current $120bn per month. Altogether the TGA runoff, asset purchases, could see reserves increase to close to $4tn by end-2020.
Curve Steepening to Remain Limited – Until Funding Competition Resumes
Based on my scenario, there would be a large increase in Treasury net coupon issuance, net of Fed purchases in H2 relative to H1. However, while the Treasury funding needs are unprecedented, its overall issuance in H2 2020 is likely to be much smaller than in H1. Lastly, the increase in Fed reserves to about $4tn could also support a bid for Treasuries. This suggests that the Treasury could term out a small amount of its debt with limited impact on the curve.
At the same time the curve tends to become responsive to Treasury issuance once competition for funding increases. This suggests that a faster than expected recovery could make it more difficult for the Treasury to fund its extraordinary deficit. For instance, once mass immunization gets underway, economic behaviours could normalize and households and businesses start spending their large savings (please see Will Mass Immunization Turn Out Negative For Markets?). In such an instance, corporate issuance would likely pick up as businesses would borrow to meet pent-up demand. At the same time, the Fed would no longer be able to maintain its extreme dovish stance. Recent news on vaccine development suggest this scenario could be a closer prospect than assumed by Fed, Treasury or markets.
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.
(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.)