Long end Treasuries are what keep me up at night

I’ve been traveling around Asia all summer and am finally back from vacation. We are long overdue a post on what’s been happening with the Treasury market and the US fiscal position. I believe there are always 3-4 main things driving most asset prices in global macro at any given moment, and part of the challenge of being a trader is knowing what they are and how they are developing. In my opinion, the three big things driving macro right now are:

1. Factors influencing supply and demand in long end Treasuries

2. US growth and inflation

3. China growth and inflation

This post will focus on #1, as rising long end yields has been the trigger for the current correction in global equity prices and will continue to rise in importance for the foreseeable future.

A recap and my opinions on noteworthy events in the Treasury market over the past several weeks:

July 28 - the Bank of Japan lifted the cap for 10 yr yields to +1.00%, causing a selloff in the JGB and global bond market. Historically, Japanese institutions have been large buyers of Treasuries as a source of yield, so Treasuries sold off on concerns that Japan will be buying fewer Treasuries as they now have to compete with higher JGB yields on an FX hedged basis. However, I don’t think this move makes a significant impact at current levels of yield as FX hedged Treasuries have been unattractive vs JGBs for a few quarters already, and Japanese institutions tapered their purchases of Treasuries a while ago. Due to the extreme inversion of the yield curve, the annual cost of maintaining a short usd/jpy FX hedge exceeds the yield one can get on a 10 yr or 30 yr Treasury. As a result, Japanese institutions can’t capture the yield differential between US Treasuries and JGBs without taking significant FX risk.

Aug 2 - Fitch downgraded the US from AAA to AA+, citing a high and growing debt burden, erosion of governance, and increasing government deficits. The announcement was negative for sentiment and triggered a selloff in equities and long-end Treasuries. Because the US is still rated Aaa by Moody’s, the downgrade didn’t trigger any forced selling by institutions, nor does it trigger any governance rules that prevent institutions from buying Treasuries as a risk-free asset. I think the negative sentiment from the Fitch downgrade will blow over, at least until the market starts to speculate on a downgrade by Moody’s.

Aug 2 - The US Treasury announced they will be increasing issuance of notes and bonds this quarter.

Treasury plans to increase the auction sizes of the 2- and 5-year by $3 billion per month, the 3-year by $2 billion per month, and the 7-year by $1 billion per month.  As a result, the auction sizes of the 2-, 3-, 5-, and 7-year will increase by $9 billion, $6 billion, $9 billion, and $3 billion, respectively, by the end of October 2023.

Treasury plans to increase both the new issue and the reopening auction size of the 10-year note by $3 billion, the 30-year bond by $2 billion, and the $20-year bond by $1 billion. 

Treasury plans to increase the August and September reopening auction size of the 2-year FRN by $2 billion and the October new issue auction size by $2 billion. 

The table below presents, in billions of dollars, the actual auction sizes for the May to July 2023 quarter and the anticipated auction sizes for the August to October 2023 quarter:

The increase in issuance was anticipated, but it was the size and timing (right after the Fitch downgrade) that caused a negative market impact in long-end Treasuries. The rise in yields triggered a slide in equities, and the market is still struggling to recover from the drawdown.