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USTs find comfort in falling inflation; Eye on higher coupon supply
Treasuries have continued to turn a blind eye to the risks/repercussions of BoJ YCC adjustment, and instead have focused on the comforting news this morning that inflation is indeed trending lower (i.e. PCE deflator 3% YoY versus 3.8% prior). Accordingly, yields have trended lower still today in a bull-steepening move while the major domestic equity indices are all in the green in the early-afternoon trade as investors eye a potential 'Goldilocks' economy on the horizon (Dow +0.66%, S&P +1.06%, Nasdaq +1.98%).
The benchmark 10py note yield is last 2.8bps lower at 3.971% while the 5s30s spread is 2.8bps wider at -17.7bps. Red SOFR futures are posting 3 to 3.5 tick gains while SOFR swap spreads are narrowly mixed amid below-average activity overall, if best seen in the 10y tenor. In the backdrop, IG issuance is offline today after $14.65bn priced this week which was well below initial estimates of $25-$25bn.
Looking ahead, Treasury is set to increase coupon sizes at the August refunding which will be the first of several quarterly increases to UST's coupon calendar. Strategists at BofA anticipate that “coupon increases will continue through the February refunding quarter and be more concentrated at the front-end and belly of the curve, consistent with previous adjustments. Coupon sizes will test but remain below the peak observed in mid '21. UST WAM should remain stable with the size increases.”
BofA had increased its coupon supply expectations vs the May refunding due to three important factors: 1) higher financing need both this fiscal year & going forward, 2) longer Fed balance sheet runoff / QT, 3) UST starting coupon buyback operations in calendar year '24. BofA discussed each below:
- ”…Deficits throughout the fiscal year have trended above our economist’s expectations due to higher spending and lower than realized revenues. Accounting for the year-to-date deficit & incorporating what UST is expecting for Q3 suggests that financing needs will total around $1.8tn in FY '23. This creates greater urgency for UST to front-load coupon adjustments in August. Higher financing needs this year has resulted in higher deficit forecasts for FY '25 and skews risks to the upside as we anticipate that spending may increase next year alongside a more muted growth backdrop.
Over the longer run, supply is expected to increase dramatically relative to GDP. With supply likely growing faster than dealer balance sheet capacity over time, we expect market functioning and liquidity to steadily deteriorate – especially around periods of economic or geopolitical shocks. This should also support a trend of tightening swap spreads, especially at the longer end which historically shows more sensitivity to supply.
“…QT outlook is expected to factor into Treasury’s supply decisions in coming quarters. Our supply base case assumes that Fed QT ends in June '24 after the Fed's first cut is delivered. However, there are material risks that QT continues for longer, consistent with Powell’s comments at the July FOMC. QT adds $720b annually to UST financing needs, assuming the Fed’s $60b monthly redemption caps are reached. The longer QT goes on the more UST needs to finance through public issuance.
“…Buybacks do not change net supply; they do require larger gross Treasury issuance. For a required net coupon supply to cover financing need, the presence of buybacks results in a larger gross issuance amount. We anticipate the distribution of this gross issuance between bills and coupons ultimately will likely be managed holistically as the share of bills as % of marketable debt that UST wants to target. Buybacks expected in Q1 ’24.
Elevated coupon supply poses increasing risk to Treasury market functioning, and to the extent that supply surprises vs expectations, cheapening vs OIS. especially if the economy remains resilient & demand weak. We see risks that the August refunding reinforces need for higher supply & raises concern about UST demand. Upward shocks to supply or very weak demand could benefit a short spread position out the curve.”
SOFR swaps – 2s -6.75bps (unch), 3s -12.625bps (-0.375bps), 5s -20.375bps (+0.125bps), 7s -27bps (+0.25ps)*, 10s -26bps (unch), 20s -62.75bps (+0.125bps), 30s -65.5bps (unch).
*adjusted for 0.7bps give.