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Last week’s U.S. Treasury market volatility is raising uncomfortable questions about investor capacity for absorbing the deluge of U.S. government debt set for sale this month.
Up to now, money managers have defied fears that the trillions of dollars of new debt issuance would overwhelm the market, with investors taking down record-large auctions without much fuss. But after a dismal debt sale last Thursday, analysts are re-evaluating assumptions that supply would have a limited impact on bond prices and yields.
“We have never seen before these amounts. That’s definitely a test for the Treasury market,” Bastien Drut, chief thematic macro strategist at Paris-based CPR Asset Management, told MarketWatch.
Net issuance of Treasury bonds and notes are set to hit an all-time high of $414 billion in March, almost the twice of the previous record, according to Drut’s calculations.
The record supply comes at an difficult time for the bond market as analysts struggle to define yield levels where debt should trade in the face of uncertainty about the size of another round of fiscal stimulus from Congress, an economic recovery as coronavirus vaccines are rolled out, and the timeline for normalization of the Federal Reserve’s easy-money policies.
That uncertainty sparked a bond-market selloff last week that pushed debt prices lower, and sent the 10-year Treasury note yield TMUBMUSD10Y, 1.413% as high as 1.60% on Thursday, by some estimates, a 12 month high. Since then, the benchmark maturity has retreated to 1.41%.
The bond yield surge coincided with the worst showing in a 7-year note auction since the U.S. Treasury reintroduced the debt maturity in 2009.
The 7-year note auction TMUBMUSD07Y, 1.082% tailed by 4.2 basis points, the most in the auction’s history and an indication of poor investor appetite. The tail is the gap between the highest yield the Treasury sold in the auction and the yield before the auction began.
“I’m not sure if that was a one-off,” said Drut, who noted previous Treasury debt auctions were already showing signs of declining demand before last week.
One concern is Treasury markets as they are currently set up are ill-prepared for sharp and volatile swings in yields, especially when coupled with one-way trading.
Those fears appeared to be confirmed last Thursday when dealers, faced with a crowd of sellers but few willing buyers, may have been forced to push yields sharply higher in order to clear the unsold debt from the 7-year note auction off their balance sheets, according to Gang Hu, managing partner at Winshore Capital Partners.
“The market is under a bit of strain. The market resiliency is tested because the size of balance sheets for trading are not going up, but the size of auctions are,” said Lawrence Dyer, head of U.S. rates strategy at HSBC, in an interview.
Market participants say there’s a ready solution available to the Fed.
The central bank could extend regulatory relief introduced last April on capital requirements for banks that had exempted Treasurys from being treated as assets in calculations of the so-called supplementary leverage ratio.
Under the current rules, banks must have capital equal to at least 3 per cent of their assets, with that share rising as high as 5% for so-called systematically important financial institutions.
Analysts say the continued relaxation of these rules would help ease up some of the balance-sheet constraints that had prevented broker-dealers from acting as an intermediary last March when the U.S. government bond market temporarily broke down.
“It’s a fix that’s available if it’s needed,” said Dyer.
