Bond Traders Await Treasury's Verdict on Supply as Taper Looms

(Bloomberg) -- The bond market is gearing up for one of the most significant Treasury refunding announcements in recent memory, and it may spark a wild ride.

Treasury could signal at its quarterly refunding Wednesday where it expects to boost issuance when the Federal Reserve begins paring the amount of cash it plows into government debt as it winds down its $4.5 trillion balance sheet. The central bank said last week that move is coming “relatively soon,” leaving many analysts anticipating more specifics in September and a potential kickoff of tapering in October.

Depending on which maturities Treasury chooses to add to, the yield curve is at risk of getting whipsawed. Any sign the government will increase sales across coupon-bearing Treasuries would steepen the curve, some analysts say. Longer tenors tend to be more vulnerable to additional supply, partly because there’s a wider range of buyers of shorter debt.

“The curve is likely to show much more volatility,” said Priya Misra, head of global rate strategy at TD Securities in New York. “We should get a sense of how Treasury plans to fund the Fed’s portfolio run-off and that will be key.”

In traders’ eyes, the likelihood that Treasury will use this refunding to begin to unveil issuance changes increased after it queried dealers about their outlook for the Fed’s adjustment and how Treasury should respond. TD predicts the size of three-, 10- and 30-year sales will be unchanged from last quarter, totaling $62 billion. That means any increase would come in the next refunding in November.

Treasury Secretary Steven Mnuchin’s interest in extending the weighted average maturity of U.S. debt as borrowing costs remain near historic lows makes it likely the increase in sales will span maturities, JPMorgan Chase & Co. strategists say. They predict that approach would steepen the curve.

Five-Year Consideration

For Misra at TD, the most likely scenario is that Treasury sells more debt with maturities as long as five years, which would allow the government to keep its average maturity fairly steady while minimizing debt-service costs.

Benchmark 10-year yields rose five basis points last week to 2.29 percent, while two-year yields were little changed at 1.35 percent. That gap between the two rates, a measure of the yield curve, rose four basis points to 94 basis points, about its average for the past month.

There’s another big event ahead with implications for the yield curve: Traders will monitor wage data in the labor report on Aug. 4 as they fine-tune their outlook for the pace of Fed rate increases. 

The market-implied probability that the Fed tightens policy again this year is about 40 percent, based on OIS and the Fed effective rate. Investors may further temper expectations for another 2017 rate hike should the wage data show inflation remains subdued.

What to Watch

• Aug. 4 brings July labor data, forecast to show the jobless rate fell to 4.3 percent. Average hourly earnings may show a monthly increase of 0.3 percent, the biggest since February.
• Treasury on Aug. 2 holds its refunding announcement, which includes the release of quarterly documents and a press conference.
• All eyes will be on Fed speakers for insight into the timing of balance-sheet reduction, with Cleveland Fed President Loretta Mester and the San Francisco Fed’s John Williams speaking at separate events Aug. 2
• Other data include PCE and ISMs Aug. 1, ADP employment Aug. 2, as well as jobless claims and durable goods on Aug. 3

To contact the reporter on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net.

To contact the editors responsible for this story: Boris Korby at bkorby1@bloomberg.net, Mark Tannenbaum, Dave Liedtka