By Komson Silapachai
After the increase in Treasury issuance in July, and concerns around the sustainability of the fiscal deficit, investors spoke loudly, demanding a higher compensation (term premium) for taking on duration risk. To that end, the focal point on the US yield curve has shifted from the front end, as the Fed has indicated they are largely done, while long-term interest rates have risen to a level unseen for over 15 years. We believe that the issuance profile along with the level of rates will constrain investing and economic activity from the private sector, weighing on risk appetite as well as economic growth.
1) From the Front End to the Long End: The first half of the year was marked by a shift higher in short-term interest rates, but since the Treasury refunding announcement on July 31st, longer maturities have been the dominant driver of the yield curve.
2) Treasury Issuance Highest Since COVID-era: The US Treasury has issued a large amount of Treasuries in recent months to fund spending, eclipsed only by the COVID era. The bulk of the issuance has taken place through T-bills, although coupon issuance has increased as well.
3) T-Bill Issuance Absorbed by Money Market Funds Shifting from Reverse Repo at the Fed: Money market funds have shifted from the Fed’s reverse repo facility to T-bills during the current issuance episode in which the Treasury has issued $1.2T of T-bills since June. This has softened the effect that issuance would have on the broader market as bank reserves have remained largely stable. However, the capacity for more issuance continues to dwindle.
4) Interest Rates Rising to Restrictive Levels: Real interest rates are hovering at restrictive levels compared to GDP as the differential is near zero. We think the rise in term premium along with the elevated issuance profile amidst a fiscal deficit could “crowd out” broader investment by the private sector as well as economic activity and result in an economic slowdown in 2024.
5) Very Little Value in Spread Sectors Outside of MBS: MBS continues to provide an attractive relative value versus corporates, with the MBS basis now trading above BBB corporates despite being AAA-rated.
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