January 30, 2024
Letter to the Secretary
Dear Madam Secretary:
Since the TBAC last convened in late October, the US economy has continued to expand and inflation has moderated. Financial conditions have eased with higher equity prices and lower Treasury yields. The rapid rise and fall in longer-term Treasury yields reflects a variety of factors, including expectations for monetary and fiscal policy, which we will address after surveying recent economic developments. The US economy remained resilient through the fourth quarter of 2023, with Q4/Q4 real GDP advancing 3.1% supported by strong consumer spending. Job growth has slowed substantially but ended 2023 at a solid 165k three-month moving average pace. The unemployment rate has been stable around 3.7% after rising from a low of 3.4% reached in April. A range of data suggest supply and demand of labor are becoming less imbalanced. Continuing claims for unemployment insurance increased last year, the hiring rate fell to its lowest level since 2014 and job openings continue to normalize lower. The sustained expansion has led many economists to revise up growth estimates and revise down subjective recession probabilities. The median probability of the US entering recession in the next six months in the Federal Reserve Primary Dealer Survey fell from 50% in June to 33% in December.
Despite the stronger-than-expected activity data, core inflation has slowed more rapidly than most forecasters expected. In the first half of 2023, core PCE inflation increased at a 4.0% annualized rate. But in the second half of the year, core PCE inflation slowed to 1.9%, just below the Fed’s 2% target. Much of the slowing was due to declines or slower increases in goods prices as supply disruptions continued to normalize. Recent disruptions to global trade from developments in the Middle East have led transportation costs to rise, although oil prices have declined since October. Shelter inflation has slowed, but is running at 5.3% on a six-month annualized basis, stronger than the 3-4% pace that prevailed prior to 2020. Six-month non-shelter core services inflation as measured by PCE is only modestly elevated at just below 3% annualized, but the CPI analog accelerated to 4.5% in December. Services inflation is also being supported by various wage growth metrics running at 4-5%.
Market and survey-based measures of inflation expectations have fallen together with measured core and headline inflation. Five-year inflation breakevens, as measured by the difference between yields on nominal Treasuries and TIPS, stand at 2.25%, down about 25bp since October and well below levels that prevailed in 2022. University of Michigan year-ahead inflation expectations peaked at 5.4% in April 2022, but have steadily declined to 2.9% in the most recent reading, similar to levels that prevailed prior to the pandemic. Falling consumer inflation expectations, rising asset prices, and perceived easier access to credit have led measures of consumer sentiment to increase.
Over the intermeeting period, 10-year Treasury yields declined toward 4.0% after having risen to close to 5.0% over the previous three months. Market concerns around large deficits, which were partially responsible for driving yields higher, appear to have waned. However, long-term fiscal projections have not changed substantially; the need to fund larger deficits may continue to present an upside risk to Treasury yields. The rapid decline in Treasury yields also reflects the surprisingly rapid slowdown in core inflation and associated investor expectations for less restrictive monetary policy.
Investor concerns regarding the fiscal trajectory seemingly peaked last year as softer demand and increased Treasury issuance contributed to higher interest rates. Longer-term yields then declined after the last refunding announcement, which reflected coupon size increases of slightly less than median expectations in longer maturities. While well within the distribution of possible outcomes, the issuance decision was perceived by investors as potentially showing some response to market conditions. It is important to note that the fundamentals of the forecast fiscal path and associated issuance have not changed substantially: the US budget deficit is expected by most forecasters to remain elevated in 2024 after the primary deficit registered 3.4% of GDP in 2023 and rising interest expense brought the overall deficit to 5.9% of GDP. This suggests markets will remain sensitive to fiscal policy developments and plans for Treasury issuance.
Over the prior three months, investors became more confident that the Federal Reserve would not raise policy rates further, in good part due to Fed officials’ suggestions that tighter financial conditions through higher long-term yields would substitute for planned hikes. Later in 2023, Fed officials communicated that lower inflation and labor supply and demand coming back into balance would warrant rate cuts – if only to keep real policy rates from becoming more restrictive. This message was made more concrete at the December FOMC meeting where the median “dot” for policy rates at the end of 2024 was lowered by 50bp. Interest rate markets now imply about 130bp of rate cuts over the course of 2024, down from 50-75bp of cuts implied in October.
Consistent with this interpretation of the volatility in yields, various measures of the additional yield or “term premium” investors require to hold longer-term debt have declined over the intermeeting period. Two commonly used term premium models (Kim-Wright and Adrian, Crump, and Moench) suggest that the majority of the recent rise and subsequent fall in Treasury yields is attributable to movements in “term premium.”
Fed officials have begun active public discussion of plans to slow and then stop balance sheet reduction. Some Fed officials have specifically noted the rapid decline in excess liquidity in the reverse repo facility (RRP) from above $2 trillion in mid-2023 to a recent low of just below $600 billion. The decline in RRP usage largely reflects money funds finding yields on Treasury bills and private repo more attractive relative to the RRP. Reserve balances remain at $3.5 trillion, about $500 billion above levels from one year ago. Repo rates and fed funds effective exhibited modest volatility over year end that suggests some financial institutions are once again needing to pay higher rates to source liquidity.
Fed communications indicate that the Bank Term Funding Program will be allowed to expire after March 11th. The facility allows banks to fund the par value of Treasury and mortgage-backed securities for up to a one-year term. Banks are funding $161 billion of collateral with the program.
Slowing or ending the $60 billion in monthly Treasury runoff associated with the Fed’s balance sheet reduction program would decrease Treasury’s need to issue debt to the private market. Treasury yields declined relative to yields on matched-maturity interest rate swaps (the swap spread tightened) reflecting investor expectations of the Fed’s winding down balance sheet reduction leading to lower net issuance.
In light of this fiscal and economic backdrop, the Committee reviewed Treasury’s February 2024 Quarterly Refunding Presentation. Based on the marketable borrowing estimates published on January 29, Treasury currently expects privately-held net marketable borrowing of $760bln in Q2 FY 2024 (Q1 CY 2024), with an assumed end-of-March cash balance of $750bln. The borrowing estimate is $55bln lower than what was cited at the October refunding, primarily due to projections of higher net fiscal flows and a higher beginning of quarter cash balance. For Q3 FY 2024 (Q2 CY 2024), privately-held net marketable borrowing is expected to be $202bln, with a cash balance of $750bln assumed at the end of June.
Relative to the estimates they provided in October 2023, primary dealers slightly decreased their estimates of borrowing needs for FY 2024, and slightly increased them for FY 2025, though they noted risks to the upside in both years. This reflected the potential for a mild recession, the onset of which has been pushed further out. Solid Q4 2023 GDP data echoed this sentiment.
Dealers also reflected the increased market focus on the dynamics in the very front end, both as reserves move from an abundant to an ample regime, and as Fed officials began discussing the tapering of Quantitative Tightening (QT). Views on the timing and scale of QT taper contributed to median issuance expectations, as well as shifts in the distributions across calendar years. It was noted that some market participants expected a taper to start this spring and conclude in the fall of 2024 as economic weakness would drive rate cuts this year. However, some participants expect QT to persist until an ample level of reserves is reached, even in the presence of rate cuts.
There were similarly distributed views on the natural plateauing of the RRP, with most expecting a run down to zero, but some looking for a sustained low level of reserves there, in the $200-300bln range. Both of these factors were thought by the Committee to be important components of support for T-bills in 2024. There was outsized support for T-bills from the Money Market Fund community in 2023, which may wane as inflows slow. However, larger reinvestments as QT tapers (and, potentially, if mortgage paydowns begin to be reinvested into Treasuries) could provide support in 2024. Of course, T-bill valuations versus repo and other short instruments will remain a driver of demand as well.
The Committee then moved to review the one charge of the quarter, which examined the drivers of investor preference for the futures versus the cash market of US Treasuries (often referred to as “the basis”), or vice versa. The charge specifically delved in detail into the drivers most relevant for asset managers and leveraged funds, the most significant generators of net open interest in the futures market. Net open interest from these two constituencies has grown meaningfully in the last two years, though it is roughly in line with the growth of the Treasury market in aggregate over that period. The offset of open interest positions across the two constituencies is notably consistent over the last decade and across tenor points on the curve.
The presenting member reviewed drivers for asset managers’ net long positions in active funds, finding financing certain active and/or non-index portfolio allocations to be the most significant driver. While repo is available as a financing tool in certain funds, expense reporting and operational hurdles provide strong incentive to instead use Treasury futures. It is notable that the change in Morningstar’s expense reporting in 2018 to include interest expense coincided with a significant ramp up in futures open interest from the asset manager community. Members highlighted that interest expense is a more meaningful hurdle in higher rate environments, and one likely underappreciated by market participants. While the average annual cost of replicating the Bloomberg Treasury Index with futures (a proxy for the cost of using futures versus repo as leverage) was discussed as being in the range of ~45bps annually, that remains significantly lower than the average return generated with credit overlays.
In the discussion, there was agreement among members that leveraged funds’ futures open interest was largely driven by intermediating Treasury purchases for the asset manager community. While leverage can vary across strategy and is not publicly available, there was discussion about reasonable estimates. For example, a market convention for rates-RV strategies is to describe leverage in 10-year equivalents, which can better normalize the riskiness of RV trades at different points across the yield curve. However, it is not necessarily consistent with an unadjusted accounting leverage calculation. A hypothetical rates-RV strategy might employ 20x leverage in the TY cash/futures basis, requiring posting 44% of a fund's capital in futures initial margin, leaving 56% in unencumbered cash. The return on capital for such a strategy could be 9-10% or higher, depending on the particular risks that the rates-RV strategy pursues within a cash/futures basis strategy.
The Committee largely felt that the dynamics driving the basis trade could be better understood and appreciated the opportunity to address that with this charge. While the existence of the net offset of leveraged funds’ versus asset managers’ open interest in futures is effectively driven by or facilitated by leverage on both sides, the Committee did not feel like this, in and of itself, was cause for concern, especially in light of the growth of the US Treasury market. That said, the charge found that there could be metrics worth monitoring. Specifically, with the advent of required repo clearing, there will be an opportunity to gather better data on exposures and leverage. Also, the cross-correlation between views on credit and Treasury basis valuation was worth noting, in that if asset managers use their Treasury books to fund outflows, that could put pressure on the basis trade. In essence, Treasury futures open interest is more a function of asset manager view on credit valuations than their view on Treasury valuations themselves.
The Committee then discussed the recommendations for auction sizes for the current and next refunding quarters. The Committee felt one more round of coupon increases, with the composition of increases mirroring those from November, was most appropriate. The majority of the Committee shared this view, though there were a few members who preferred two quarters worth of smaller increases, and a smaller minority who preferred indicating a similar set of increases in the May-July 2024 refunding quarter.
There was good discussion among members as to the many factors that are likely to impact borrowing needs relative to expectations. Among others, these factors include the evolution of Fed monetary policy (including for SOMA portfolio redemptions and investments) and changes in the fiscal outlook (potentially related to economic growth and tax receipts). While there is always some degree of uncertainty about borrowing needs, the Committee felt that the wide range of factors and the high degree of uncertainty associated with such factors at this time was notable. The Committee was comfortable recommending auction size increases for just the current quarter, despite what will be a sustained higher T-bill share in coming quarters. While issuance needs this quarter were modestly lower amid an improved outlook, the Committee appreciates Treasury’s regular and predictable approach and recommends a repeat of the November auction size increases as the best course of action. That said the Committee recognizes it may be appropriate over time to consider incremental increases in coupon issuance depending on how the current uncertainty regarding borrowing needs evolves.
The Committee favored increasing TIPS issuance in line with historical moves and noted the value of the product in Treasury’s overall issuance suite. It was noted that the TIPS share is set to trend lower over time, both due to faster growth in nominals and also the maturity profile of TIPS outstanding.
Of course, given the considerable uncertainty surrounding the economy and projected borrowing needs, Treasury will need to retain flexibility in its approach.
Respectfully,
Deirdre K. Dunn
Chair, Treasury Borrowing Advisory Committee
Colin Teichholtz
Vice Chair, Treasury Borrowing Advisory Committee