Mnuchin’s Long-Bond Curve Ball Dares the Flatteners

(Bloomberg Opinion) -- A week ago, Federal Reserve Chair Jerome Powell lulled bond traders to sleep. Today, Treasury Secretary Steven Mnuchin jolted them awake.

Wall Street was already bracing for record-sized debt sales from the U.S. Treasury, given the federal government's rapid increase in spending to combat the coronavirus crisis. But what almost no one saw coming was Mnuchin's willingness to aggressively ramp up sales of the longest-dated securities. The department announced Wednesday that starting in August, it would increase 10-year note auctions by $6 billion, the just-implemented 20-year bond auctions by $5 billion and 30-year bond auctions by $4 billion.

In total, the Treasury will issue $108 billion of 10-year notes, $69 billion of 20-year bonds and $72 billion of 30-year bonds over the next three months. Of the 22 primary dealers that Bloomberg News's Elizabeth Stanton surveyed, 21 of them forecast smaller boosts to those maturities. Only Morgan Stanley got it right. 

The department, which had previously leaned heavily on short-term bills to offset the sudden surge in government spending, said it plans to use “long-term issuance as a prudent means of managing its maturity profile and limiting potential future issuance volatility.” That's probably true, but it's also likely not the whole story.

Lately, the $20 trillion U.S. Treasury market has been in a slumber, with a gauge of bond volatility falling to an all-time low on July 30. After Powell reiterated last week that he and his fellow policy makers “are not even thinking about thinking about thinking about raising rates,” the benchmark 10-year yield reached the lowest in more than two centuries, per research from Jim Reid at Deutsche Bank AG. All this led DoubleLine Capital's Jeffrey Gundlach to tweet on Monday that there were “many layers of meaning” in the world's biggest bond market being brought to heel.

It's important to view the Treasury's latest announcement through the lens of its unprecedented coordination with the Fed throughout the Covid-19 pandemic, as evidenced by the central bank's vast array of new lending programs. The Fed, of course, only directly influences short-term interest rates through its main policy rate and forward guidance. It can have a more indirect impact on longer-term yields through the composition of its Treasury purchases, which currently run at about $80 billion a month.

It stands to reason that for the sake of the financial system, the Fed would prefer a U.S. yield curve that's a bit steeper than it is right now. The difference between five- and 30-year Treasuries is 101 basis points, compared with about 191 basis points in July 2012 when the five-year yield set its previous record low. The spread exceeded 300 basis points in late 2010. To nudge the curve higher, the Fed could just stop buying long-term debt, but given the market's breakdown in March and the shaky economic recovery, it's understandably loath to signal any sort of tapering.

So if the Fed can't buy less, then the Treasury can just issue more. It achieves the same goal. 

“The U.S. Treasury was aggressive yet again in growing coupon issuance,” Jon Hill, vice president of U.S. rates strategy at BMO Capital Markets, wrote in a note after the announcement. “The latest auction performance has clearly increased confidence inside the U.S. Treasury that sharp increases in auction sizes will be met with strong demand.” Jim Vogel at FHN Financial said the department moved “from baby steps to giant in coupon auction sizes” relative to the previous quarter.

The Fed, by contrast, has done the opposite. Its balance sheet grew by almost $3 trillion from March through June, but has since held steady around $7 trillion for several weeks. Financial markets are humming again, and Powell seems content to move slowly on rolling out additional easing measures like yield-curve control and enhanced forward guidance, particularly given that traders are already acting as if those policies are in place.

Supply alone will only go so far — in fact, the yield curve steepened to an almost two-week high on Wednesday, but then quickly pared that move. Ultimately, even tens of billions of dollars in additional debt is just a drop in the bucket. Still, the policy actions in the past week indicate that Powell and Mnuchin are both eyeing the Treasury market and will use their tools to push it and pull it until interest rates are where they want them. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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