Market Analysis

Column: US Treasury uses debt sales as a cat and mouse game: Mike Dolan

Amos Simanungkalit · 28 Aug 20248.8K Views

The U.S. Treasury faces significant debt obligations in the coming year, yet its proactive management of debt maturity suggests that the widely predicted U.S. debt "crisis" may not materialize soon.

Currently, the Treasury’s funding challenges are considerable, with more than half a trillion dollars in bills and bonds up for auction this week alone.

However, nearly three-quarters of this week's issuance consists of bills maturing in 12 months or less, which could roll over at progressively lower rates if U.S. interest rates decrease as anticipated.

Despite the routine nature of large weekly Treasury sales, many investors remain concerned about the increasing levels of government debt and the need to secure willing buyers.

Torsten Slok, chief economist at Apollo Global Management (NYSE: APO), is the latest to raise alarms with his "Top 10" list of Treasury-related concerns.

Slok highlights that $9 trillion in government debt is set to mature over the next year, debt servicing costs now represent 12% of government spending, trillion-dollar deficits are projected for the next decade, and the debt-to-GDP ratio could double to 200% by mid-century.

His message is clear: Be prepared for challenging auctions, potential credit rating downgrades, and the ongoing risk that long-term bond investors may demand a significant "term premium" to hold long-dated Treasuries.

Yet, by managing the maturity profile of its debt, the Treasury is showcasing one of its key strategies to avoid a debt crunch in the near term.

Even though the weighted average maturity of all marketable debt remains above pre-pandemic levels at nearly six years, short-term bills maturing in one year or less now constitute 22% of the total—up from the 10%-15% range typical before COVID-19.

With policy rates currently above 5%, this short-term issuance is expensive.

However, the outlook changes dramatically if the Federal Reserve begins cutting rates next month and reduces rates by over 200 basis points over the next year, as futures markets currently predict.

MANAGING MATURITIES

Is the Treasury intentionally influencing the U.S. government debt market? Analysts at CrossBorder Capital argue that it is, through a policy of "active duration management" (ADM) aimed at suppressing yields.

In a report titled "US Treasury Bribes World's Smartest Investor," CrossBorder examines the potential effects of this bill-heavy maturity profile on less-scrutinized debt tenors, like the benchmark 10-year Treasury note.

The analysts compare its yield to that of higher-yielding U.S. mortgage-linked bonds, adjusted for interest rate sensitivity and "convexity."

Their model reveals a significant 100-basis-point gap between the two, which they attribute entirely to this unofficial ADM policy.

CrossBorder suggests that such a discount could lower the projected U.S. 2050 debt-to-GDP ratio by a full 35 percentage points.

The downsides, though less apparent, are still significant.

If 10-year yields are suppressed to the extent suggested, this could explain why the yield curve has been inverted for more than two years without the predicted recession materializing.

However, the loss of this tool for forecasting the economy and inflation has its costs.

Furthermore, continuing to shorten the average maturity profile of the debt increases rollover risk. Periodic disruptions, such as debt ceiling debates or temporary default threats in the bill market, could have an outsized impact if the reliance on bills continues to grow.

While flooding the bill market with new issuances may reduce near-term debt servicing costs, the strategy faces risks if the Fed's policy cycle shifts again or if the economy enters a period of persistent higher inflation and interest rates.

This risk is particularly relevant given the current political climate. Without a shift in fiscal policy in the coming years, the U.S. debt profile will eventually require difficult adjustments.

Ironically, the absence of market turmoil in the meantime could reduce the political will to address deficits and debt, potentially exacerbating the issue.

However, it is evident that government debt managers have multiple strategies and tactics at their disposal to navigate the current period without sparking the crisis that many have predicted.

Whether these measures are merely temporary solutions is another matter. But, based on recent history, it seems risky to assume that the Treasury and Fed will fail to keep this situation under control for the foreseeable future.