The Federal Reserve's battle with inflation will be the principal driver of yields on Treasurys even as the US government floods the market with more and more bond issuance.
The Treasury plans to issue a near-record $1.859 trillion of debt in the second half of 2023, $274 billion more than previously planned in May, as it refills its coffers after running down reserves to fund operations during recent debt ceiling negotiations between Congress and the White House.
The increase in supply is expected to weigh on the price of bonds, pushing up yields at a time when the Federal Reserve is actively offloading its holdings and foreign demand wanes in Japan and China. The volumes have raised questions about sustainability, with Fitch Ratings pointing to the growing debt burden in its recent downgrade of the US credit rating. Yet market watchers are not particularly concerned about the government's borrowing plans.
"All else equal, increases in government issuance of Treasury debt weighs on Treasury prices and lifts yields. However, I think the main driver of Treasury demand is the outlook for Fed monetary policy, inflation and economic growth," said Kathy Bostjancic, chief economist at Nationwide Mutual.
Market can absorb new issuance
Treasury issuance is planned to top $1 trillion for only the second time in history in the third quarter. The previous occasion was in exceptional circumstances when $2.753 trillion was sold in the second quarter of 2020 at the height of the COVID-19 pandemic with the aid of a supportive Fed buying bonds and setting rates at 0%.
This time two of the big sources of demand for US government debt have been reducing demand. The Fed is winding down its holdings through quantitative tightening, while Japan and China — the two largest foreign holders of US debt — have shed their combined holdings by $228.2 billion, or 10.5%, in the 12 months to May.
The ability of the market to absorb the extra issuance is not a major concern, according to Padhraic Garvey, regional head of research for the Americas at ING. The Fed still owns some $8.208 trillion in assets, including bonds, while another $5.500 trillion in money market funds held by investors could go into longer-duration bond holdings, Garvey said. Additionally, $1.799 trillion returns to the Fed each day through its reverse repurchase facility, a program in which the Fed sells securities and buys them at a higher price the next day, which helps keep bond yields under control by ensuring liquidity.
Meanwhile, other sources of foreign demand have filled much of the gap left by China and Japan.
"In the end, there is always a price at which bonds get taken down at auction. The only issue is to what extent that price needs to fall [yields rise]," Garvey said. "I can see some pressure along these lines. At least to the extent that anticipation of extra issuance is an issue in itself."
Treasury yields, which move opposite to prices, have generally risen in August, with the benchmark 10-year yield reaching 4.19% on Aug. 14, a high for the month and close to the recent peak in October 2022.
Recent Treasury auctions have suggested demand is generally strong, particularly for 3-year and 10-year Treasurys, Garvey said.
Yet longer-dated bonds are suffering from weaker demand. Some $23 billion of 30-year bonds drew slimmer demand during an Aug. 10 auction despite offering the highest coupon since 2011.
The weakness was remarkable considering US government data released Aug. 11 showed inflation excluding food and energy prices rose 0.2% month over month in July, analysts at Saxo Bank wrote in a same-day research note. The increase tied with June as the lowest monthly rises since February 2021.
"It wasn't enough to relieve worries concerning upcoming inflation and an increase in Treasury supply," the analysts said.
Still, all of the auctioned debt sold, and while some durations are more popular than others, the market is still expected to absorb any new issuance.
"It's just a question of at what price," said Joel Prakken, chief US economist with S&P Global Market Intelligence.
Inflation
The future direction of prices will be directed by the Fed's battle with inflation, with any hint that prices will remain higher for longer making the volume of issuance a bigger issue.
The annual pace of the core consumer price inflation — a measure of rising prices that excludes food and energy — ticked lower to 4.7% in July from 4.8% in June, a modest decline but moving in the right direction.
"Our baseline forecast has one more rate hike in it, we assume in November," Prakken said. "Between now and the September meeting, there are two consumer price index reports and those reports will be critical in determining whether we get an additional rate hike."
While the rate hiking cycle may be near the end, Market Intelligence economists do not expect rate cuts for at least another six months as low unemployment puts upward pressure on services and prices.
"The prospect of lower inflation and an end to monetary tightening will support demand for Treasurys; however, Treasurys will rally the most once it's time for the Fed to cut rates," Bostjancic with Nationwide Mutual said.