July 30, 2024
Letter to the Secretary
Dear Madam Secretary,
Since the TBAC last met in late April, slowing inflation and a loosening labor market have led Treasury yields to move lower with growing expectations of rate cuts from the Federal Reserve. Yields on 10-year Treasuries have fallen by close to 40 basis points, with 2-year Treasury yields lower by around 50 basis points in the last three months. Various political developments are increasingly in focus as the November election approaches, but so far have had a limited impact on asset prices.
After a 3.7%QoQ annualized increase in Q1, core PCE inflation slowed to 2.9% in Q2. The monthly inflation readings for May and June were particularly subdued. Goods prices, while not as soft as in the second half of 2023, have moved largely sideways despite elevated shipping costs. Anecdotes from companies suggest limited ability to raise consumer prices further. Shelter inflation, which has remained strong for much of the last three years, slowed to a typical pre-pandemic monthly pace in June. There remains some “stickiness” in certain elements of non-housing related services inflation, such as financial or medical services.
Federal Reserve officials have indicated that recent inflation data have helped to increase confidence that inflation is sustainably slowing to their 2% target, but that some more evidence could still be required to begin lowering rates. Market participants increasingly expect a first rate cut at the September FOMC meeting, with close to 25 basis points of cuts priced for that meeting, and just over 60 basis points of cuts priced for this year as a whole.
Chair Powell indicated in congressional testimony on July 9th and 10th that risks around the Federal Reserve’s dual mandate of price stability and maximum employment are now more balanced. The risk of stronger inflation is balanced by the risk of a softer labor market as inflation has slowed but the unemployment rate has risen.
Monthly establishment survey (payroll) job growth remains strong, averaging 218k jobs added per month over the last year ending in June. But strong payroll job growth has also occurred alongside a more consistent rise in the unemployment rate in recent months. The unemployment rate has increased from a low of 3.4% in April 2023 to 4.1% as of June 2024. Job openings have also declined, and with the increase in unemployment, the ratio of job openings to unemployed workers has returned to 1.2:1, in line with pre-pandemic norms. The divergence between stronger establishment survey job growth and the rising unemployment rate could be explained by difficulties capturing the effects of substantial immigration or measurement issues, including falling survey response rates.
Activity has also slowed in recent months from a very strong pace in H2-2023 but with aggregate output continuing to rise. Real GDP growth rose 1.4%QoQ SAAR in Q1 and 2.8% in Q2, with final private domestic demand rising 2.6% in each quarter. Retail spending was softer than forecasters expected in most months of 2024. Some services spending remains strong, such as medical services, but more discretionary services consumption, such as at restaurants, has slowed. Data on the manufacturing sector have been mixed but business equipment investment rose a strong 11.6% in Q2. Housing activity has weakened more consistently in the past few months, with new construction pulling back and home sales falling as thirty-year mortgage rates remain close to 7%. Residential investment fell 1.4% in Q2 after rising 16% in Q1.
On May 1, the Federal Reserve announced it would begin to slow the pace of its balance sheet reduction. The cap on Treasury securities redemptions was reduced from $60 billion per month to $25 billion beginning in June. Agency debt and agency mortgage-backed securities will continue to mature with proceeds that exceed the $35 billion per month cap reinvested into Treasuries, although this cap has not been binding recently. Balances in the Federal Reserve’s reverse repo facility declined steeply over the second half of 2023 from a peak of over $2 trillion, but this decline slowed in 2024 with balances just below $400 billion as of July 17. Reserve balances are just above $3.3 trillion. Chair Powell in congressional testimony indicated that balance sheet reduction has “a good ways to go”, suggesting it is likely to continue even with upcoming rate cuts.
Ten-year Treasury yields have fallen to around 4.2% in recent weeks, lower than this year’s highs around 4.6% but still above the lows at the start of the year around 3.9%. This pullback from the year’s peak has been roughly split between a decline in real yields and a decline in inflation expectations, reflecting that both inflation and activity have slowed.
In light of this fiscal backdrop, the Committee reviewed Treasury’s August 2024 Quarterly Refunding Presentation. Based on the estimates published on July 29, Treasury currently expects privately-held net marketable borrowing of $740bln in Q4 FY 2024 (Q3 CY 2024), with an assumed end-of-September cash balance of $850bln. The borrowing estimate is $106bln lower than what was announced in April. For Q1 FY 2025 (Q4 CY 2024), privately-held net marketable borrowing is expected to be $565bln, with a cash balance of $700bln assumed at the end of December.
Primary dealers had revised both their deficit estimates and privately-held net marketable borrowing estimates slightly higher over each of FY 2024, 2025, 2026, resulting in additional forecasted borrowing of about $400bln in aggregate over the FY 2024 to FY 2026 period. Committee members noted the varied interest rate assumptions used by primary dealers, the Office of Management and Budget, and the Congressional Budget Office. Some Committee members noted that these projections assume current law, which could contribute to elevated near-term uncertainty around these forecasts.
The Committee appreciated the update on the successful implementation of Treasury’s liquidity support buyback program. Treasury communicated that dealers saw buybacks as modestly supportive of liquidity, but the limited size and already-liquid market conditions meant that it was difficult to ascertain the full impact of the program. The Committee offered some comments on the distribution of interest in certain CUSIPs in the program, certain parts of the curve (e.g. in TIPS) or among potential participants. Treasury noted that the contours of the program could be adapted over time as it moves beyond the initial phase, and welcomes feedback and suggestions on possible enhancements to both execution and reporting.
The Committee then reviewed the charges for this quarter. With the first charge, the Committee welcomed the opportunity to revisit historical guidance on the optimal T-bill share of debt outstanding. For the past five quarters, the Committee has made recommendations for coupon issuance decisions which resulted in running a T-bill share higher than 20% of outstanding debt. Treasury’s goals of minimizing the cost to the taxpayer over time, with regular and predictable issuance, were central to the debates around these recommendations.
The presenting members highlighted four main areas with which to consider T-bill issuance: financing costs over time, regular and predictable issuance of securities, market structure and investor demand, and debt maturity distribution. First and foremost, the Committee felt that T-bill issuance should continue to act as a shock absorber, allowing coupons to be issued in a regular and predictable manner. Historically, this has necessitated operating with a T-bill share as high as 30-35% for short periods.
In order to re-examine considerations for T-bill issuance over the medium and long term, the presenting members used the Optimal Debt Model to more closely review the trade-off between average interest costs and volatility in deficit financing. Within the context of the model, on balance, T-bills provide lower average costs than other securities (though this is heavily dependent on term premium assumptions), and higher volatility of debt service costs. As noted in the charge, volatility around funding costs is reduced when T-bill share is at or below 20%. While the Model provides a helpful framework for discussion, Committee members felt its results were only one consideration of many.
There was significant debate among the members as to the value of “share” as a metric. While most felt T-bill share was not a target in and of itself, members agreed that monitoring share (alongside other metrics, such as absolute and net issuance) could continue to be valuable. As a continuation of this, most members felt that a lower bound of T-bill share was more important than an upper bound. While the appropriate lower bound can vary due to factors such as total T-bills outstanding, overall supply of high quality liquid assets, and the effects of money market fund reforms, among other things, the Committee felt that, currently, 15% remained a lower bound which supports healthy market functioning.
When considering a medium or long term average, the Committee felt that T-bill share should not be the first consideration in issuance decisions, noting the many other factors highlighted in the charge. Specifically, the group was focused on prioritizing regular and predictable issuance patterns in coupons, and the trade off between interest rate costs and the volatility of debt financing and rollover risk. Most Committee members felt that, currently, a T-bill share averaging around 20% over time appears to provide a good trade off between these factors. However, the Committee unanimously noted the importance for Treasury to retain flexibility to adapt this over time with evolving market dynamics.
The second charge reviewed by the Committee involved developments in, and the outlook for, demand for Treasuries. The presenting member noted that recent trends have shown increased Treasury demand from more price-sensitive buyers like households (including hedge funds) and money market funds, while reviewing historical holdings data across a multi-year period.
On a go-forward basis, the presenting member posited that demand for Treasuries could remain supported among various buyers. Bank demand could shift from Agency MBS to Treasuries due to regulatory changes, particularly in short-dated Treasuries as the duration of assets could shorten to match liabilities following banking stresses in the spring of 2023. Money market demand for government securities has been increasing ahead of upcoming SEC mandatory liquidity fee requirements taking effect on October 2. Hedge fund and household demand could remain robust as inflation eases, improving the value of Treasuries as a hedge for risk assets. The Committee discussed the interplay of asset manager and hedge fund holdings, including through the basis trade, and the implications for repo financing (both now and post implementation of the SEC’s final rule on clearing of US Treasury repo trades). The Committee felt that the outlook for investor demand in US Treasuries is modestly positive, though some members noted the risk of a move higher in term premium based on the deficit outlook.
In terms of issuance for the upcoming quarter, the Committee recommended that Treasury keep nominal coupon auction sizes unchanged. Turning to TIPS, the Committee supported increasing the 5y TIPS auction by $1bln (and the $1bln increase of the reopening of the 10y TIPS in September). With the information currently available, the Committee felt that unchanged nominal coupons, with a $1bln increase to the January 10y TIPS issuance, would likely be appropriate for the subsequent quarter. The Committee felt that continued marginal increases in 5y and 10y TIPS auctions were appropriate when considering the share outstanding, current TIPS maturity profile, and the limited number of TIPS auctions each quarter.
The Committee also discussed the potential impact of debt ceiling constraints on Treasury’s issuance strategy in FY 2025, especially limits to Treasury’s flexibility and the likelihood of increased costs to the taxpayer. The periodic occurrence of debt ceiling episodes drives elevated uncertainty in funding costs. Additionally, these episodes can cause significant economic uncertainty, affect financial markets, and impact U.S. credit ratings. As noted in letters written both as part of the Quarterly Refunding process, but also independently in 2011, 2016, 2021 and 2023[1], lack of resolution of the debt ceiling runs the risk of undermining the foundation of the U.S Treasury market.
Respectfully,
Deirdre K. Dunn
Chair, Treasury Borrowing Advisory Committee
Mohit Mittal
Vice Chair, Treasury Borrowing Advisory Committee