Not "Fitch downgrade"? What really shakes the "anchor of global asset pricing" is the "US Treasury Tsunami"!

In order to cope with the worsening fiscal deficit situation, the US Treasury Department has increased its quarterly bond issuance for the first time in two and a half years, leading to Fitch Ratings downgrading the US government's credit rating a day earlier.

On Wednesday, the US Treasury Department announced that it will sell $103 billion in long-term bonds next week, exceeding the previous $96 billion and slightly higher than the level expected by most traders. At the same time, the US government plans to issue debt of various maturities on a larger scale, issuing approximately $1 trillion in bonds during the quarter from August to October 2023.

The surge in issuance indicates that the US deficit situation continues to worsen. Fitch Ratings downgraded the US sovereign credit rating by one notch to AA+ on Tuesday. Fitch stated that the US government's debt burden remains high and continues to increase, and it is expected that the fiscal situation will continue to deteriorate over the next three years.

The upcoming "US bond tsunami" will test the market's demand for US bonds, with the yield on 10-year US Treasury bonds soaring to the highest level since November 2022.

It is worth mentioning that due to its strong liquidity, the yield on 10-year US Treasury bonds is known as the "anchor for global asset pricing". Its surge often causes severe turbulence in financial markets and further increases the possibility of a recession.

The US Bond Tsunami is Coming!

The US government plans to issue debt of various maturities on a larger scale, issuing approximately $1 trillion in bills and bonds over the next three months. The table below shows the auction sizes of US bonds from May to July 2023 (in billions of dollars), as well as the expected auction sizes for the next three months.

Among them, long-term debt will increase significantly in the initial issuances, with the largest increase in the issuance sizes of 10-year, 20-year, and 30-year bonds occurring this month. The issuance of shorter-term bonds, such as 2-year, 3-year, and 5-year bonds, will steadily increase.

Issuing more long-term bonds helps alleviate the inversion situation when long-term yields are relatively low. CreditSights strategists expect the yield curve to return to normal within the next year. After the news was released, the 2/30-year US Treasury yield curve steepened further, returning to levels near the mid-July peak.

Looking ahead, the US Treasury Department stated that these changes will ensure that the issuance scale remains consistent with the medium- and long-term borrowing needs. In the coming quarters, it may be necessary to gradually increase the scale of bond issuance.

Regarding the potential issuance scale of US bonds, Barclays Bank pointed out in a report yesterday:

Given the possibility of continued high borrowing demand (the borrowing demand in the fourth quarter of the Treasury Department was $850 billion), we believe that the state of increasing the bond auction scale will continue for several quarters. Even if the Federal Reserve ends its quantitative easing policy in the first half of next year, the wide budget deficit will still require the Treasury Department to issue more bonds.

We believe that the issuance scale will eventually exceed the peak during the pandemic (except for the 7-year and 20-year terms due to special reasons). Therefore, we expect the Treasury Department to signal further increases in the auction scale at the upcoming meeting. If the net issuance amount of bonds in fiscal year 2024 approaches $2 trillion and $1 trillion in fiscal year 2023, we would not be surprised.

Who will take over?

With the Fed's balance sheet shrinking, the upcoming tsunami of US bonds is causing concerns.

With a large influx of US bonds into the market, who will step in? Analysis suggests that the US bond yields are similar to junk bonds a few years ago, and they will eventually attract almost everyone to buy. Alphaville pointed out:

We estimate that for every 1 percentage point increase in long-term yields, non-central bank participants' demand for US Treasury bonds will increase by 11%. Based on the estimated elasticity of yields for different industries, we infer the yields under different scenarios of quantitative tightening. For example, we found that assuming the Federal Reserve reduces its balance sheet by about $215 billion, it would cause a 10 basis point increase in long-term US bond yields, with other conditions remaining unchanged.

Currently, US Treasury bonds are still the most liquid asset in the world, and the 10-year US Treasury bond yield is known as the "anchor of global asset pricing." However, rising interest rates will exclude private investments and weaken stock values.

Analysis suggests that with the Federal Reserve raising interest rates for over a year, the ability of the US government to change its fiscal path is becoming increasingly limited, unless it takes drastic measures such as excessive money printing that could lead to political disasters. Without taking aggressive measures, the government is almost certain to spend more than it earns, and the continuously rising risk-free interest rates will exclude private investments and weaken stock values.

What's worse is that the US government losing fiscal maneuverability may result in facing the next crisis, whether it's financial, health-related, or military, without the simple solution of throwing money at it. It may require domestic sacrifices such as increased taxes, inflation, and reduced welfare.

On Tuesday, Fitch downgraded the long-term foreign currency debt rating of the United States from AAA to AA+, with the outlook changing from negative to stable. Fitch stated that the downgrade of the US rating reflects the expected deterioration of the country's finances over the next three years, the overall high burden of government debt, and its continuous growth. Fitch Ratings predicts that tightening credit conditions, weakened business investment, and slowing consumption will lead to a mild recession in the US economy in the fourth quarter of this year and the first quarter of next year.