The true "black swan" of US bonds: Only central banks can intervene in the future storm

The situation of US bonds may not be as optimistic as the market imagines!

Last week, the US fourth-quarter bond issuance plan was finalized. According to the US Department of the Treasury's announcement, the federal government is expected to borrow $776 billion in the fourth quarter of this year from October to December, a decrease of $760 billion from the expected $852 billion at the end of July. With the reduction in supply impact and the Federal Reserve's pause in interest rate hikes, many analysts are optimistic that the turning point for US bonds has arrived.

However, according to the latest analysis from the media and Goldman Sachs, the US Department of the Treasury's slowdown in fourth-quarter bond issuance is aimed at guiding market expectations, and it is expected that future bond issuance will remain at high levels.

Under the massive issuance of bonds, the market faces numerous challenges. From the demand side, the Federal Reserve is implementing quantitative tightening policies, and it is difficult for the private sector alone to absorb the bonds. Furthermore, the real concern lies in the disruption of market liquidity. If funds flow back from US bonds to the Federal Reserve, combined with the Federal Reserve's quantitative tightening, liquidity will be quickly drained, and the market's demand for risk and safe assets will decrease significantly.

Slowing down bond issuance? The US Department of the Treasury is just shifting market attention

According to media analysis, the US Department of the Treasury's bond issuance plan is actually aimed at "imitating the Federal Reserve" to guide market expectations and shift market attention.

Specifically, although the US Department of the Treasury is slowing down fourth-quarter bond issuance, it indicates that future bond issuance will increase:

Based on the projected medium- and long-term borrowing needs, the plan is to "gradually" increase the size of most bond auctions from November 2023 to January 2024, and it is expected that an additional quarter's size will need to be increased after that to meet its financing needs.

As shown in the chart below, after a slight decline in the issuance of long-term bonds in 2022, the issuance volume of long-term bonds has risen again and is likely to continue indefinitely. Looking ahead, the total amount of US bond issuance will be enormous. According to the Congressional Budget Office's (CBO) forecast, the proportion of US bonds to US GDP may increase from the current 120% to 200% in the long term.

The "delaying plan" given by the US Department of the Treasury is to have fewer long-term bonds and more short-term US bonds. The aggressive wave of short-term US bond issuance has increased the proportion of tradable debt to 20.4%, which is higher than the 15-20% range recommended by the Treasury Borrowing Advisory Committee (TBAC), although the TBAC pointed out that short-term US bonds are expected to remain above 20% "under reasonable assumptions until the second quarter of 2025". TBAC refers to the Treasury Borrowing Advisory Committee, a group composed of major participants in the bond market such as Citigroup, JPMorgan Chase, and BlackRock. They are responsible for providing debt issuance advice to the Treasury Department.

TBAC also expressed concerns about the supply of US Treasury bonds in its report to the Treasury Department:

• The expectation of a significant increase in bond supply is fueled by the large and sustained deficit.
• Except during periods of economic recession/high unemployment, the US deficit is at its upper limit, making the supply of US Treasury bonds a focal point (recently, the increase in US bond yields is mainly due to term premiums).
• The narrowing of swap spreads may indicate a supply-demand imbalance caused by an increase in US bond issuance.

The adjustment in wording also took into account the advice of TBAC. In its report, TBAC explicitly pointed out that after the Treasury Department released the wording "it may be necessary to further gradually increase the issuance size in the coming quarters" in August, the 10-year US Treasury yield sharply increased. Therefore, in the November report, the Treasury Department adjusted the wording to "increase the size for an additional quarter."

TBAC explained that if the Treasury Department maintains the growth pattern announced in August for the next two quarters:

• The supply of US Treasury bonds will reach a new record, significantly increasing the duration of next year's bond supply.

Analysis suggests that the wording of "increase the size for an additional quarter" by the Treasury Department helps to delay the arrival of a catastrophic moment. Yellen actually did not emphasize the Treasury Department's reliance on long-term bonds, but instead tried to shift the focus to short-term Treasury bond issuance and the Federal Reserve's reverse repurchase mechanism. Most people expect this mechanism to become the source of all short-term Treasury bond funds until the Federal Reserve's reverse repurchase balance is depleted.

Private Sector Unable to Bear the Massive Bond Supply

From the demand side, the Federal Reserve is implementing a quantitative tightening policy, and the private sector may be unable to absorb the massive bond supply.

First, let's look at primary dealers (i.e., banks that purchase bonds at auctions and then make a market for them), which are crucial to the US Treasury bond issuance system.

As the volume of debt issuance increases, they are buying more US Treasury bonds than they can sell, leading to an increase in the yield of 10-year or longer-term US Treasury bonds compared to swap spreads (i.e., narrowing of swap spreads). However, traders originally hedged bond price risks and earned the interest rate differential through swap transactions, so there was no reason for primary dealers to hold a large amount of US Treasuries. Therefore, it is reasonable for the US Treasury Department to reduce the issuance of long-term bonds. Currently, the borrowing cost of 30-year US Treasuries is 0.6 percentage points higher than the swap rate.

Another issue is that financial regulations after the 2008 financial crisis have hindered banks from absorbing bonds without restrictions. The Federal Reserve's quantitative easing policy had previously made up for this shortfall, but it is no longer the case now. The Federal Reserve is actively selling bonds to tighten monetary policy.

In addition, less regulated participants, such as hedge funds, have increased their net short positions in US Treasury futures to the highest level since 2006, according to data from the Commodity Futures Trading Commission (CFTC). This is likely because they act as traders by buying Treasury bonds and selling Treasury futures.

However, as warned in a report by the Bank for International Settlements in September, this is a risky trade that could quickly unravel. In March 2020, when the pandemic triggered risk concerns, US Treasuries were actually sold off. This proves that although people expect safe-haven assets to appreciate in times of difficulty, reducing leverage by funds and traders has the opposite effect.

These situations indicate that the private sector may not be able to provide ample liquidity to the bond market as implied by officials' fiscal plans.

Furthermore, historically, the positions of US traders have been negatively correlated with the steepness of the US Treasury yield curve. This means that only when bond yields significantly exceed the interest rates for depositing cash in banks will these real-money buyers intervene. This situation has already begun to emerge: cash-strapped traders are pricing long-term bonds at a discount, leading to an increase in "term premium," which in turn raises borrowing costs and puts pressure on the stock market. Moreover, the term premium may further increase in the future.

The real black swan is the "instant" evaporation of market liquidity, which is more disruptive than weak demand.

As the TBAC pointed out, since June 1, the US Treasury Department has issued $1.5 trillion in US Treasuries to meet borrowing needs and rebuild the Treasury General Account (TGA) from a lower level. (TGA is simply the "wallet" of the US federal government, where US Treasury issuances and tax revenues are deposited, and almost all of the US federal government's expenditures are paid out through this account)

However, most of this cash does not come from banks' balance sheets, but from over $1 trillion deposited in the Federal Reserve's reverse repurchase agreements. As the explosive growth of US Treasury issuances/cash from the Treasury Department, the total amount of the Federal Reserve's reverse repurchase agreements has significantly decreased.

Taking a closer look at the relationship between "ON RRP, short-term Treasury bonds, and TGA cash," the chart below shows that for most of the second half of this year, every dollar raised from issuing short-term Treasury securities to supplement the TGA account came from the Fed's reverse repo mechanism. As the funds in the TGA account continued to rise, the balance of the Fed's reverse repo was gradually depleted.

Furthermore, unlike long-term Treasury bonds, there are currently no reserve requirements for short-term Treasury bonds. In theory, as long as there is sufficient reverse repo funding, they can be sold without any market issues. However, although there is currently ample reverse repo funding, it is also being rapidly consumed. As of November 7th, the scale of the Fed's overnight reverse repo agreements (RRP) has just exceeded $1 trillion, a decrease of $1.5 trillion from the peak on December 30th last year. At this rate, the most important reverse repo, which seems to be an endless source of liquidity, may be completely depleted by January.

As Goldman Sachs strategist Borislav Vladimirov pointed out in a report:

The U.S. Treasury's shift towards relying more on issuing government bonds to fund the U.S. deficit has led to short-term Treasury rates being higher than the RRP rate, and the higher return has continuously attracted investors to transfer funds from ON RRP to take on short-term Treasury bonds, causing a decoupling of Treasury bonds and risk assets.

As money market funds shift from ON RRP to short-term Treasury bonds, it has withdrawn about $800 billion in liquidity from the Fed's overnight reverse repo agreements (RRP), offsetting some of the impact of QT on market liquidity.

Borislav Vladimirov believes that the problem lies in:

If the issuance of Treasury bonds decreases and the correlation between Treasury bond yields and risk assets normalizes, we may see a reversal of funds flowing back into ON RRP in a short period of time, coupled with the Fed's QT, which could quickly push reserves to their upper limit.

In fact, Goldman Sachs believes that this development is likely to trigger significant risk parity and dollar volatility, leading to the third phase of the R** event, forcing the Fed to immediately ease policy and stop quantitative tightening.

It is worth mentioning that the Fed can pre-emptively prevent liquidity volatility by setting an upper limit on RRP, which would suppress short-term Treasury bond yields in a risk-averse environment, align bank reserves with quantitative easing, and exert downward pressure on short-term Treasury bond yields. Therefore, the RRP upper limit will be beneficial to risk assets in the short term. Media summaries point out that currently, the balance of reverse repurchase agreements (RRP) by the Federal Reserve is being depleted. Similar to the overall financial conditions in the market, RRP operations also have a similar reaction. Once the Federal Reserve appears to loosen its hawkish stance, the market starts to celebrate, which in turn forces the Federal Reserve to become even more hawkish. If the continued reduction of RRP operations is deemed to have adverse consequences for the market, the flow of funds in the market will immediately reverse.

Therefore, it is possible that within a few weeks, the balance of reverse repurchase agreements by the Federal Reserve will significantly increase, short-term Treasury bonds will be sold in the open market, and cash will be held in the "Federal Reserve as a counterparty" safe repository. This means that market liquidity will evaporate instantly, and the demand for risk and safe assets in the market will sharply decline.