Treasuries: Supplying Answers to the Yield Question

June 12, 2014 11:00 AM
By Zane Brown

The decreasing supply of U.S. government debt is a likely cause of the recent Treasury rally. But this trend may be nearing its end. 

Why have U.S. Treasury yields dropped since the beginning of 2014? Explanations abound. Most address increased demand for Treasuries emanating from concerns about a weakening U.S. economy, a jump in geopolitical risk, pension funds and insurance companies opportunistically snapping up government debt to match liabilities, or Treasuries’ attractive yield relative to those in other developed countries. A more convincing explanation may be the reduction in supply of Treasury debt on the market.

Reduced U.S. government spending, combined with increased tax revenues, produced a meaningful drop in Treasury supply during the January–May 2014 period. According to TreasuryDirect, the U.S. Treasury raised $168 billion in the first five months of 2014, compared with $338 billion in the year-ago period. Many investors expected the Federal Reserve’s ongoing tapering of Treasury purchases would create extra supply that, in turn, would pressure prices lower. In fact, Treasury supply contracted faster than the Fed’s purchases declined. Lower supply, combined with increased demand from the factors cited above, likely pushed Treasury prices higher.

Last year, at a total quantitative easing pace of $85 billion per month, the Fed bought $225 billion in Treasury securities in the first five months. This amounted to about 67% of the $338 billion offered by the Treasury.  This year, the Fed only purchased about $165 billion—but it was nearly all of the $168 billion offered by the Treasury. (All data on Treasury offerings from TreasuryDirect.) Despite economists’ expectations of an increase, the yield on the benchmark 10-year Treasury note is lower today than it was at the beginning of the year.

Is this likely to continue? Can we expect lower yields over the balance of the year? Probably not. The Fed’s Treasury purchases are expected to decline to zero by October 2014. Someone else will have to buy that supply. Whoever that is will likely do so at a lower price and a higher yield. In addition, supply will be affected by seasonal factors. The historically strongest revenue period for the Treasury—the first five months of the calendar year—is behind us. Over the balance of the year, while a lower budget deficit will mean less supply than in the comparable period in 2013, the monthly supply of newly issued Treasuries likely will be higher than we have seen so far in 2014. Deutsche Bank expects net Treasury issuance over the balance of the year will be around three times the pace set in January to May, based on Congressional Budget Office (CBO) estimates. Even if supply is only marginally higher, the complete absence of the Fed in the market is likely to result in some price pressure on Treasuries—unless other buyers step in to pick up the slack. 

What about the longer term? Treasury supply dropped this year to reflect a near 30% improvement in the U.S. budget deficit, which the CBO project will fall, from $680 billion in 2013 to $492 billion, in 2014. The improvement in the deficit likely will be less dramatic in 2015, with only a modest projected decline to $469 billion. After that, the CBO projects deficits to rise not only in absolute terms but also as a percentage of a growing economy, from 2.6% of gross domestic product in 2015 to about 4% 10 years later. 

It appears, then, that the best news about a decline in Treasury supply may already be behind us. What are your thoughts on what comes next for Treasuries? Let us know in the comment section.

Zane Brown is Partner and Fixed Income Strategist for Lord Abbett.

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