Bonded servitude

Things look increasingly ugly for the Treasury market

This post, “Bonded Servitude” contained an error. Originally I claimed “it has become clear there has been relatively more paying of fixed rates at the long-end of the curve since April.” This was wrong.

In fact, there has been relatively more receiving of fixed rates at longer maturities. The conclusion should have been that the curve steepening that has occurred since SVB went bankrupt faces an irregular headwind from swap end-users. I have changed the text to reflect this.

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In the last weeks uncomfortable reality has assaulted the Treasury bond market. The yield curve has steepened (dis-inverted) a little even as the Fed raised rates to the highest level in 22 years. Prolonged negative carry is a heavy burden. Is the bond hangover of 2022 about to be followed with an intense migraine? It is looking increasingly likely.

Fitch downgraded U.S. credit rating due to “a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters.” That’s been the case for ages. But the agency went on: “the repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.” They are not the only ones to have noticed. Many of us treat rating agency pronouncements with a degree of contempt, but Fitch is right about the unsettling politics of U.S. government debt dynamics.

Recent headline budgetary politics have been dominated by the Fiscal Responsibility Act (FRA) which ended the Debt Ceiling standoff at the end of May. The Congressional Budget Office (CBO) estimated the FRA would reduce budget deficits by about $1.5 trillion over the 2024–2033 period relative to the baseline budget projections. Yet, even with the Fiscal Responsibility Act of 2023, the CBO government debt is likely to rise to 130% of GDP in 10-years.

Photo by Edge2Edge Media on Unsplash

The Quarterly Refunding announced continued massive issuance of T.Bills in the near-term but suggested that if Treasury reach their target level on Bills, the issuance burden will switch to annual coupon supply in the $1.5-2.0 trillion range ‘forever’.

And a couple of weeks ago the the U.S. Treasury published its Long-Term Budget Outlook with the usual stark projections of ever-growing debt stock - see charts below.

source: U.S. Treasury

Plus the BoJ caused bond holders to ponder the effects of removing YCC (my view, not much). And on top of all that, Fed QT will continue to add supply to the market for the next 4 years or so. Finally, Fed Fund rates don’t look close to turning lower.

These bearish factors are partially countered by an emerging feature in the swap market. It has become clear there has been relatively more receiving of fixed rates at the long and medium tenors of the curve since April.

The following two charts show the evolution of the 2s10s swap curve (top) with a gradual but distinct shift to receiving fixed at longer tenors (bottom chart).

Of course, the yield curve is unusually inverted, and if investors are becoming accustomed to higher rates for longer, then it makes sense for longer tenors to see yields rise. Negative carry is a horror show! Yes, the yield curve needs to normalise to improve the long-term prospects of the banking sector. Persistently higher rates and steeper curve, is a paradigm to which we are not accustomed. It seems it is also meeting resistance from swap end-users.

If I was a betting man, and I was, I’d bet on yields continuing to rise. What would change my mind? A clear signal that the Fed has shifted to cutting mode. Unfortunately, there is no sign of that. I’m embarrassed to admit my earlier call for a September rate cut was sadly misguided.