When we commented last night on the Senate’s proposed bipartisan “deficit-busting” spending deal – one which will raise spending caps by $300bn over the next two years and incorporate a suspension of the debt limit until March 2019 – we observed that “the agreement will achieve one thing – lead to a surge in US debt issuance, and – by implication – even higher yields, leading to an even steeper drop in the market, not to mention more frequent VIX-flaring episodes.“
With yields jumping and stocks sliding, so far this prediction appears on target.
As a reminder, one month ago Goldman predicted that US debt issuance would more than double, rising from $488bn in 2017 to $1,030 billion in 2018.
Of course, now that the spending caps have been raised by $300 billion, this implications is that the US deficit will surge, and net Treasury debt supply – needed to fund the deficit – in 2018 will get even bigger, something which is duly reflected in today’s surging 10Y yield.
But how much will the proposed deal spike the US deficit by? In a note from BofA’s chief rates strategist, Mark Cabana, we find the answer:
Assuming the bill becomes law, our deficit and Treasury supply estimates will be marked higher.
Yesterday’s bipartisan Senate agreement included a deal to fund the government beyond 8 February and boost spending levels for defense and non-defense programs over the next two years. The $300bn increase over the next two years is modestly larger than we expected and caused us to raise our deficit forecasts by $35bn and $20bn to $825bn and $1,070bn, respectively, assuming the law passage (Table 1).
Not all of the cap increase will translate into direct spending in each fiscal year given actual outlays can be spread over several years. Moreover, some of the increase in the spending caps came from budget gimmicks that just shifted funding toward domestic nondefense spending from other budget provisions; this is why our deficit estimates boost is below the total cap increase. The increase in disaster relief spending was generally in line with our estimates, which did not result in any revisions.
As a result of the highest deficit forecast, BofA has also revised its prior Treasury supply forecast higher:
We have addressed the increase in deficit financing need by raising our estimate of Treasury coupon auction sizes across the curve and relying on slightly greater bill supply in the near term. Specifically, we have amended our issuance forecast to include continued modest increases in 2- and 3-year auction sizes at the May refunding by an incremental $1bn/month while raising all other nominal coupon sizes by $1bn over the quarter. We then expect Treasury will continue with a gradual $1bn auction size for all nominal tenors over upcoming quarters until early 2019 (Table 3). These adjustments result in a more stable Treasury WAM over time (Chart 1).
The problem here is that the Treasury’s most recent quarterly borrowing estimates already imply a very large increase in marketable borrowing supply over the course of 1-2Q, especially in relation to the past five years (Chart 2). As we discussed last week, the Treasury’s 1Q estimates suggest it will end up raising nearly $300bn in bills over the course of the quarter with most occurring between now and end March (Table 4).
The Treasury’s 2Q borrowing estimates also imply a much larger borrowing need and expected increase in bill supply versus recent history. And with the likely increase in the debt limit, there is now even more upside risks to the Treasury’s 1Q borrowing estimates given it might target a higher 1Q cash balance vs the $210bn it previously indicated.
Here, BofA adds, that using the Treasury’s marketable borrowing estimates as a guide, it still expects a sizeable Treasury bill supply boost in the near term, but it a bit more gradual than we previously envisioned (Chart 3). “We expect to see Treasury supply increased as early as next week.”
What are the immediate market implications: as we said last night, the increase in supply following the debt limit resolution should support higher rates and a steeper curve.
We also expect that increased front-end supply should support higher repo rates and modestly tighter USD funding conditions.
Similar front-end dynamics were observed after the debt limit increase in November 2015 and subsequent large Treasury supply build. After the debt limit resolution, the Treasury raised $267bn in net bill supply over the following five weeks. During that time GCF repo increased sharply, bills cheapened, the TU-OIS moved more negative, and FRA-OIS widened (Table 5). Note that reserve manager Treasury reductions around year end and the December 2015 Fed rate hike may also have contributed to the moves at this time.
At present, BofA flags the following considerations for market participants attempting to gauge the market impact of upcoming supply
- Treasury bills should cheapen to trade flat or slightly above OIS. 3- and 6-month bills should trade at a positive spread vs matched maturity OIS, while 1m bills will likely trade near flat vs OIS. The backup in bills should cheapen discos as well and, together with higher GC repo, contribute to minimal usage of the Fed’s O/N RRP facility on non-quarter-end dates.
- USD funding conditions should tighten as (1) money markets cheapen, placing upward pressure on CP and CD rates and (2) higher Treasury cash balances with the Fed draining reserves and reducing liquidity. This should lead to wider FRA-OIS and greater demand for USD through the cross currency basis market. The market is already pricing in expectations for additional tight funding, though we see risks that near-dated contracts could widen further with the elevated supply.
Finally, amid this debt tsunami, there is a silver lining: should the deal pass, there will be no default in mid-March:
The Senate agreement also suspends the debt limit and staves off a potential Treasury default, which we projected would occur in early March without an increase. The “suspension” of the debt limit does not set a new level for the amount of debt outstanding, but instead sets a date on which the debt limit will be reinitiated. Press reports indicate the debt limit will be suspended until March 2019, which removes this issue until Congress gets beyond the mid-term elections in November. A similar process of “suspending” the debt limit has been used over recent years.
And putting it all together in one chart: lower default risk now, much higher debt supply (and debt yields) later.
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