Wall Street’s biggest bond dealers are starting to forecast that the U.S. Treasury will reduce the size of its debt auctions in coming months for the first time in three years as government revenue soars.
With the Congressional Budget Office estimating a 2013 budget deficit of $845 billion, the smallest since 2008, eight of the 21 primary dealers who trade with the Fed say Treasury may cut the amount of notes it offers that are due in five years or less as soon as July. The government hasn’t trimmed coupon auctions since 2010, a year after the economy began expanding from the worst financial crisis since the Great Depression.
Limiting the supply in a market where investors are bidding about a record $3 for every $1 of debt sold may force buyers to pay more for Treasuries at a time when demand for short-term debt has pushed yields on one-month bills below zero. The dealers’ outlook has shifted in response to a growing economy amid rising tax revenue and cuts to government spending.
“The rapidly shrinking deficit means we aren’t going to need as many Treasury bonds as we would if the deficit hadn’t been shrinking so quickly,” Edward Keon, portfolio manager and managing director of Newark, New Jersey-based Quantitative Management Associates LLC, a unit of Prudential Financial Inc., which manages $95 billion, said in a May 9 telephone interview. “There is still a very strong demand for high-quality fixed- income product on a global basis.”
Smaller Auctions
Smaller-than-forecast deficits may give the U.S. enough leeway to make it through to the end of the fiscal year on Sept. 30 without breaching the debt ceiling, which Congress suspended until May 18, according to Morgan Stanley economist Ted Wieseman. That would take pressure off President Barack Obama and lawmakers as they try to craft a budget that addresses longer- term fiscal imbalances.
Treasury, which has sold $32 billion of three-year notes each month since October 2010, may reduce the July offering of the securities to $31 billion, Thomas Simons, an economist in New York at primary dealer Jefferies Group LLC, said in a telephone interview May 6. That would be followed by $1 billion less in sales of two- and five-year notes later that month, he said.
Mizuho Securities USA forecasts cuts will begin in August for those securities, as does Morgan Stanley, which also expects the seven-year note offering will shrink by $1 billion in September followed by similar reductions to 10-year notes and 30-year bonds in October. Bank of Nova Scotia, Barclays Plc, BNP Paribas, Citigroup Global Markets and RBC Capital Markets forecast the smaller auctions will begin in the fourth quarter.
Eleven firms forecast no cuts in issuance this year, and Daiwa Securities Group Inc. and Goldman Sachs Group Inc. didn’t make projections.
Bond Yields
Yields on 10-year Treasuries, the benchmark for everything from corporate bonds to mortgages, rose to as high as 1.93 percent on May 10, the most since March 26.
Returns on U.S. bonds have averaged an 4.9 percent annually during the past five years, with the 10-year yield falling to 1.86 percent from 3.77 percent during that period even as outstanding Treasury debt has soared to $11.4 trillion from $4.7 trillion, according to Bank of America Merrill Lynch bond indexes.
The Treasury said May 10 that the U.S. posted a monthly budget surplus of $112.9 billion in April, the widest in five years. Revenue rose 28 percent to $406.7 billion while spending increased 13 percent to $293.8 billion. The deficit for the first seven months of the fiscal year ending Sept 30 shrank 32 percent, to $487.6 billion from $719.9 billion in the same period in 2012.
Treasury View
CBO forecasts show the deficit falling to $616 billion, or 3.7 percent of gross domestic product next year, and then to $430 billion in fiscal 2015. It peaked at $1.42 trillion, or 10 percent of GDP in 2009.
“Depending on how the fiscal situation develops, Treasury may decide to gradually decrease coupon auction sizes,” the department said in a statement May 1.
Barclays lowered its deficit projection to $750 billion from $850 billion May 10, while Morgan Stanley reduced its forecast to $775 billion from $860 billion, before accounting for $89.5 billion in payments by Fannie Mae and Freddie Mac to the government this year.
“The deficit improvement has been so much ahead of schedule,” Morgan Stanley’s Wieseman said in a May 9 telephone interview. “Changes that we were expecting in issuance later this year needed to be shifted forward just by the positive surprise on the budget outlook.”
Bill Sales
The Treasury may adjust sales of short-term bills while waiting to see if the budget deficit continues to contract, according to the 11 dealers forecasting no change in issuance.
While deficits are falling now, they will resume growing in coming years as government retirement and medical costs rise, according to the CBO, which forecasts a $798 billion shortfall in 2020.
“Down the road deficits begin to increase again,” William Marshall, an interest-rate strategist at Credit Suisse Group AG in New York, said in a May 6 telephone interview. “Even if the Treasury were to reduce coupon issuance in the next few years, it would quickly find itself needing to boost issuance again due to redemptions and rising deficits.”
Next page: Auctions Peak
Auctions Peak
Auction sizes peaked in 2009 as the government borrowed to revive growth after the biggest quarterly contraction since 1958. Two-year note monthly sales reached $44 billion, three-year offerings $40 billion and five-year auctions $42 billion.
The Treasury borrowed a record $2.249 trillion at its note and bond auctions in 2010, up from $581 billion in 2007. It sold $2.153 trillion last year.
Beginning in 2009 the department focused on extending the maturity of its debt to lock in record low rates, resulting in a decline in bills available to money market investors. The average maturity of U.S. debt was 64.5 months in March, up from a 24-year low of 49.4 months in 2009.
The government will be able to reduce borrowing because the economy continues to grow, while more slowly than in previous recoveries, even amid $85 billion in across-the-board spending cuts that began in March as a result of lawmakers’ inability to agree on a budget.
U.S. GDP grew at an annualized pace of 2.5 percent in the first three months of the year after growth slowed to a more- than-three-year low of 0.4 percent in the final quarter of 2012, the Commerce Department said April 26.
Emergency Cash
The economy has added an average of 179,000 jobs a month in the past two years, a faster pace than during the same period before the start of the financial crisis which began in August 2007, Labor Department data show. The country hasn’t made up the 8.7 million jobs lost since January 2008.
As the government’s need for emergency cash for unemployment and other benefits soared in 2008 and 2009, the Treasury sold $1 trillion of short-term bills, boosting the amount outstanding to $2.07 trillion.
Since then the supply of Treasury bills has fallen to $1.7 trillion, or 14.9 percent of the government’s $11.4 trillion of marketable debt outstanding, from a peak of 34.4 percent in December 2008. Securities maturing in three years or less have fallen to 49.5 percent this year from 60.2 percent in 2008, according to the Treasury.
Money Markets
The decline may mean the Treasury’s likely cut of two- and three-year note auction sizes would be aimed to limit reductions of bills used by investors in the money market, Thomas Simons, a government-debt economist in New York at Jefferies, said in an interview May 6.
The one-month bill rate dropped to negative 0.0051 percent on May 6 amid expectations of reduced sales ahead after the Treasury announced it plans five days earlier to sell between $10 billion and $15 billion in two-year floating-rate notes by as early as the fourth quarter.
James Clark, deputy assistant secretary for federal finance, said the floating notes would initially serve as a replacement for some bills, according to minutes of an April 30 meeting of the Treasury Borrowing Advisory Committee, or TBAC, the bond dealers and investors who meet quarterly with department officials.
“The floaters will ultimately take away from some Treasury bill supply,” Jerome Schneider, head of the short-term strategies and money markets desk at Newport Beach, California- based Pacific Investment Management Co., said in a telephone interview on May 9. “Overall, if the Treasury doesn’t need to borrow as much money, and we know that 2014 has a better fiscal picture than 2013, we should expect supply in general to go down.”
Bank Buying
Fewer shorter-term securities may lead to a rush to buy debt that banks may use as high-quality collateral. The need for safer assets, including government bonds, will grow by as much as $5.7 trillion by 2020 as the 2010 Dodd-Frank Act in the U.S. and capital standards set by the Bank for International Settlements in Basel, Switzerland, require more top-graded debt as loss reserves, TBAC said in a May 1 report.
“There’s already a collateral shortage,” Thomas di Galoma, head of U.S. rates sales at ED&F Man Capital Markets in New York, in a May 8 telephone interview. “If they bring smaller issues, there will be increased demand for them out of the chute.”
