The Long and Short (End) of the US Treasury Market

Last year, Bloomberg launched a new brand campaign. “Context changes everything”. I liked this tag line.

If you are a risk assets investor, you cannot invest without first placing the treasury market into context.

Let’s start with some numbers to contextualize the market we are going to talk about.

World GDP : ~US$96 Tn

Global Equity Market Cap : ~US$109 Tn

Global Bonds Outstanding : ~US$130 Tn

US Total Fixed Income Outstanding : ~US$52 Tn

US Equity Market Capitalization : ~US$50 Tn

And finally….

US Treasuries Outstanding : ~US$26 Tn

The US Treasury market, as we know, forms the basis of pricing literally every single asset in the world.

In the note below, I will talk about 2 key current aspects of the US Treasury and Money Markets. The first concerns demand for long dated US Treasuries and the second is about the state of money market.

Point Number 1 : Demand for Long dated US Treasuries

Coupon auction sizes:

The Auction size for 10 year Treasury notes has been progressively increased from US$32bn in January 2023 to US$42bn in Feb 2024. Similarly, auction size for 30 year Treasury bonds has been increased from US$18bn to US$25bn during the same period.

Key Takeaway: Coupon auction sizes have been steadily increasing to meet the funding requirements stemming from big fiscal deficits..

Coupon Auction Performance:

Generally speaking, auction performance for long dated treasuries has been relatively weak in recent times.

This week the Treasury auctioned US$67bn of 10 year and 30 year bonds. In contrast to recent trends, auction performance on these long dated securities was nothing short of stellar. For instance, Primary dealers had to take up only ~14% of the 10 year note auction, which was comparatively lower than recent auctions. And the tail on the 30 year bond was a sizeable negative 2 basis points !

Key Takeaway: While overall auction performance has been weaker than expected, it’s been far from alarming. And the latest $67bn auctioned this week had quite a stellar outcome…

Throwback to an article I wrote in early 2022 when there were initial rumblings on who would buy all this upcoming treasury issuance deluge.

$3–4.5Tn net Trsy issuance over next 3 yrs! Who will buy this debt?

Point Number 2 : Adequacy of Liquidity in the Financial System

Let’s look at the other end of the market now. Liquidity in money markets.

Rate Hikes Over; Excess Liquidity Soaked :

The consensus expectation is that rates hikes are a thing of the past. Even the Fed believes so. Money market fund managers have been pulling money out from the Reverse Repo and either buying Treasury Bills or investing into the Repo market.

The Reverse Repo balance is seen as a gauge of excess reserves in the financial system and hence indicative of liquidity conditions. The monumental build of $2.5 Tn in the Reverse Repo has come down to $550bn now. This brings the LCLOR or “Lowest Comfortable Level of Reserves” (i.e. minimum amount of Reserves needed for smooth functioning of the US banking system) into sharp focus.

Key Takeaway: The huge build up in the RRP was viewed as excess liquidity in the financial system that was not required. It is down substantially due to rates peaking, quantitative tightening and a deluge of bill issuance. But now no one knows what is the right point at which to stop…

SOFR Spikes, History Repeats?

The best indicator of adequacy of reserves is the cost of short term money in money markets. Below are 3 graphs that show year end SOFR rates. But before we get there – a quick line to provide context. During fiscal year end, Banks, which are both borrowers and lenders in the money market complex, get more conservative to “manage” balance sheet ratios and tend to “conserve cash”. i.e. reduce the amount of lending activity in the repo market.

The first graph is during year end 2021. This was when Quantitative Easing was in full effect and the system was flooded with reserves. With ample reserves, there was no undue spike up in repo rates.

The second is during 2018. This was the time that the Fed was engaging in its first Quantitative Tightening exercise. Note the SOFR spike in December.

The third is the latest during 2023 year end. Quantitative Tightening is in full swing. History is repeating itself?

The sharp spikes in December 2023 in SOFR have not gone unnoticed and the Fed is bound to take due note of these spikes. The reason why the 2018 and 2023 graphs are key is because of what happened subsequently in 2019. Post the “Repo Madness” of September 2019 when repo rates spikes and liquidity dried up, the Fed essentially had to halt its quantitative tightening and inject liquidity back into the system!

Key Takeaway: With the RRP coming down rapidly and rates still high, either a liquidity squeeze event is around the corner or the Fed might halt QT soon. It is also key to note that the Fed seems divided on whether to wait till the RRP comes down all the way to zero or stop QT much before that.

Summary:

The US Treasury market is the centre of our modern financial universe. Any ripples originating from the centre can be felt in faraway corners of the investing pond. Given the dynamics at the short end of the curve, that ripple seems around the corner. On the other hand, the US$ and the US economy still remain the cornerstone of the world. TINA at its best! While there is a ton of valid concern around fiscal largesse, long dated US treasuries will still be the go-to haven when “things” hit the ceiling!

Not meant to be Investment Advice. Do your own research. Happy investing!

Shashank Sawant

www.thecreditbalance.com

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