All Things Treasury

Mike Cloutier:

Hi everyone and welcome to a Bird’s eye view of the Bond Market podcast with Merganser Capital Management, where we invite members for our investment team to offer their analysis on the US investment grade bond markets and share insights into key economic developments. My name is Mike Cloutier, Chief Marketing Officer at Merganser Capital, and I’ll be hosting today. We’re recording this episode on Friday, February 23rd, 2024, and I’m thrilled to be joined by our very own Todd Copenhaver, Deputy CIO and Saloni Daga analyst from our credit sector team. Recently institutional and retail investors alike have been fixated on how the US government plans to finance itself amidst higher borrowing costs and what that could ultimately mean for the markets that we participate in. The last time interest rates were this high was 2007 when total debt to GDP was approximately 60%. Now that figure exceeds a hundred percent many worry who will step up and keep lending to the US government who’ve already seen large foreign investors like China pair back their holdings to treasuries in recent months. At the same time, the Federal Reserve is also in the process of normalizing their balance sheet and unwinding the historic quantitative easing program, which was used as a stimulus tool during the 2020 pandemic. Todd and Saloni, let’s dig into this topic a bit further and unpack some of the key questions in recent developments. Saloni to start, could you provide a brief background on just the overall size of the US government balance sheet and how we got to where we are today?

Saloni Daga:

Sure thing, Mike, and thank you for inviting us on the podcast. Very excited. So, in terms of the federal balance sheet, really national debt is basically standing at around $34 trillion right now, which is like you mentioned, 120% of GDP quite a bit higher than pre GFC and really both the GFC and pandemic have caused step changes in that outstanding. And if you were to look at Jan 2020 pre pandemic and what the Congressional Budget Office released for gross debt projections, they didn’t see us reaching the 34 trillion mark till 2029. So that’s pretty amazing. Yeah, so the government basically borrowed to fund the worst thing deficit picture, which currently stands at about 1.7 trillion or 6% of GDP. And it looks like deficits are going to stay elevated in large part because we are borrowing at higher interest rates locking in those debt service costs. So net interest as a percent of GDP is projected to go up.

Mike Cloutier:

So Todd, what’s the significance of this quarterly treasury refunding announcement and why is it receiving so much attention now versus historically it seemed like it was something that we saw hit the tape but didn’t really pay a lot of attention to?

Todd Copenhaver:

So the treasury refunding announcement is really what sets the stage for the size and texture of treasury issuance for the coming quarter. And really what it is, is the result of a lot of private conversations with investors trying to determine the appetite for treasuries and where on the curve there is appetite for treasuries. And really within this process, the treasury’s sort of dancing a dance with investors around trying to optimize their weighted average cost of capital. Sometimes those conversations match the overall market very well and other times they don’t. And when the supply surprises to the upside that results in gyrations in the curve as existing treasuries repriced relative to those expectations. We’ve seen quite a few instances of that in the recent past where the expectations versus reality didn’t match up and the market reacted pretty strongly. In the most recent past, once the debt ceiling was lifted, the issuance of very short-term debt increased pretty dramatically as a result of refilling the coffers of cash and matching the front end demand that was seen there. But then during the August refunding meeting, the treasury decided term out debt more in part to bring the production of bills within the recommended range, the overall debt load of approximately 15 to 20%. The pace of auction size increases has since come down, but market participants are certainly worried about supply demand imbalances as really the challenge that they are facing is not that they’re not going to pay back their debt, it’s making sure that they find a smooth transition of issuing their debt and that finding its way into long-term treasury holders.

Mike Cloutier:

So that brings me to my next question and I’ll pitch it back to you Saloni. So we have treasuries obviously has an elevated debt load at this point, historically high. What are people saying about the future refunding needs and what’s the expectation on the term structure in terms of issuing shorter term debt versus longer term debt? Where are they guiding us?

Saloni Daga:

So Mike, really future refunding needs are largely determined by the size of the deficits which are expected to grow, refinancing needs and debt service expectations. So the rising interest costs, that’s the supply side, but we also want to look at the demand side and some of the biggest buyers of these bonds is the Fed and the fed’s balance sheet has been in runoff since 2022, so a less present fed and that’s causing foreign investors and the private sector to step in and absorb this debt. When you look at foreign investors, China because of geopolitical tensions or Japan because of the rising hedging costs have kind of stepped back a little bit. But on the flip side to that, with the ongoing wars in the Middle East and Ukraine, demand for safety and dollar denominated bonds is increased. So some are stepping in. And then there’s the private sector, so that’s the asset managers, the insurance companies, banks, and they are certainly more yield sensitive buyers.

So the treasury has to think about where on the curve to issue, like Todd said, depending on who’s buying too. So to the extent the economy is strong and upside risk to inflation like we saw in the January CPI print and there’s a hawkish bend to fed policy, then these yield sensitive buyers will want to be on the sidelines and when the fed is dovish and expectations are for rates to go lower, there’s better demand. That’s kind of the push and pull or the difference between the shot and long-term issuance. And what kind of determines that.

Mike Cloutier:

Bringing this down to our level in the investment management seat, how could this expected supply reprice the treasury curve, which is obviously extremely important for managers like Merganser, given that we buy treasuries directly, but also everything else we buy is priced off of a spread to treasury, the underlying really matters here. And so the second part of that question is what are the implications for businesses and consumers because at the end of the day, the treasury market sets the base for borrowing costs and just curious to get your thoughts on that.

Todd Copenhaver:

I think it’s important to couch this topic in what that repricing would be based on, and it would be more about growing concern about the ability of the US to navigate its debt load and over the short term, maybe minor gyrations and changes in slopes between different rates based on supply and demand and how the refunding announcements are meeting expectations. But really we would need a change in people’s expectations about the US’ credit worthiness for there to be structurally higher interest rate costs. That’s not to say that that’s not impossible, it certainly is. And it’s made more complex by the way that our debt ceiling is structured where it results in these kind of shotgun agreements at the 11th hour. The rating agencies have responded to that with multiple downgrades, but I think to date we’re not yet seeing that pressure of worrying about the US being able to repay.

It does stand a reason that austerity measures are likely to be a part of our future. And it’s really a question of when until those have really come into focus that the market is likely in the short run to react to surprises to the upside on deficits as it continues to compound the problem. I think the other thing that comes through from an investment management perspective is that as these refunding announcements and treasury issuance get more complex in terms of finding the pockets of demand, the different liquidity structures of the various tenors of new issue treasuries and various types of new issue treasuries, treasury floating rate notes, seven year and 20 year treasuries (tend to be a little bit orphaned), TIPs in other market environments, not right now, but certainly a smaller part of the overall treasury universe, all of those are going to be more difficult needles to thread.

So in response to that, we’ve been less involved in seven and 20 year spaces as a result of that reduced liquidity and that reduced confidence that the curves going to be well behaved in those less liquid points. What that means for businesses and consumers is that there are going to be points where they will have to pay higher rates and that interest rate volatility is here to stay. And so with that trying to time interest rates, while we would view as always, humbling will be particularly humbling until the supply demand picture for treasuries gets a little bit more stable.

Mike Cloutier:

And so to kind of wrap this up, debt as a percentage of GDP sits at historically high levels, interest rate costs for the treasury have increased. The Fed is potentially pivoting their policy this year. It remains to be seen what’s going to happen with the US economy in 2024. Lots of differing opinions. I’d like to end with just this question as to what we think could potentially go wrong.

Saloni Daga:

Yeah, so Mike, really the major driver of the treasury curve is forward nominal rate expectations, so Fed funds and inflation. So really like you mentioned, should the economic data continue to show steady progress towards a soft landing demand should hold up. But if there’s significant upside risk to rates that would subdue demands, especially for a longer dated paper and also the Fed accelerating the pace of QT significantly could also be a big factor should things go south. For that reason.

Todd Copenhaver:

I would just add that I do think that in the short run, the likelihood that the Fed is able to guide policy cleanly seems less likely than not, and as a result of that interest rate volatility is likely to remain elevated. And so with that, it just makes their job that much harder. You could see in the short run more consternation and for that to result in them having to change tact more quickly. As Saloni mentioned, one of the major drivers of the increase in deficit has been debt service costs, and you have to recognize the endogenous nature of debt service costs and the setting of fed funds and how that dynamic is likely to present downward pressure on rates, which presents upside potential for inflation to stick around for a little bit longer. We’re really keenly focused on that dynamic is being a challenging one for fixed income investors over the coming years.

Mike Cloutier:

Alright, well I think we’re going to leave it there. This has been very informative. Todd and Saloni, thanks so much for joining today and thank you to our listeners for tuning in to another episode of the Bird’s Eye View of the Bond Market. We look forward to sharing another update with you soon and be well. Thank you.

Jeffrey Addis:

This presentation is for informational purposes only and should not be considered an investment advice or a recommendation of any particular issuer security strategy or investment. Product opinions and estimates offered constitute our judgment and are subject to change without notice as our statements of financial market trends, which are based on current market conditions. We believe the information provided is reliable, but do not guarantee its accuracy or completeness. This podcast contains or incorporates by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Actual results may differ materially past performance is no guarantee of future results.