Throughout most of the second quarter, bond investors had been somewhat lulled by the relative stability in Treasury markets as the U.S. nominal 10-year Treasury traded in a fairly narrow range. However, in the first couple of weeks of August, 10-year yields jumped by ~20bps and investors are now considering if this move portends to higher yields ahead.

The initial reaction was likely caused by early signs of some inflationary pressures. Core CPI in July surprised to the upside, reporting the strongest monthly increase (0.6%) since 1991, further supported by several months of strong retail sales and consumer activity. However, even with the strong July report, the underlying trend in inflation has downshifted, particularly within the services sectors. Instead, the catalyst for higher yields may be a shift in Treasury debt issuance and Federal Reserve (Fed) purchases in the second half of the year.

In order to provide large-scale and swift stimulus to the economy, the Treasury ramped up its bill issuance, boosting the T-bill market by 2.7tn USD year-to-date. As a result, the T-bill share of the Treasury market has risen to more than 30%, the highest share since 2009. As a consequence, the weighted average maturity (WAM) of the Treasury’s debt has declined to 61.8 months as of the end of June, its shortest level since 2011. 

In response, the Treasury appears to be making a concerted effort to extend the WAM of marketable debt outstanding back toward pre-COVD levels. However, it should be recognized why this shift in duration management is taking place. The Treasury General Account (TGA) swelled to 1.7tn USD as of August 12^th, up from 280bn USD at the beginning of the year, due to massive T-bill issuance and receipts from tax returns filed in July. Importantly, the TGA serves as the checking account for the Treasury and considering the expected path of PPP loan forgiveness and typical seasonal outlays, the TGA should decline only modestly through the end of the year. 

Given this, the TGA is unlikely to return to a more normal cash balance anytime soon. Therefore, borrowing further out on the curve is likely to significantly outpace deficit-financing needs this year. This is supported by the Treasury Borrowing Treasury’s Office of Fiscal Projections (OFP) financing estimates, which currently forecasts net privately-held marketable borrowing for coupon bonds of 447bn USD from July-September (Q4 FY2020), up from 331bn USD last quarter. Moreover, the Fed has steadied its pace of Treasury purchases at around 80bn USD/month in Treasuries, much lower than the 75bn USD/day pace seen in late March and early April. Together, greater duration supply and less Fed buying suggests yields may drift higher through the back half of the year.

All things considered, the Treasury’s WAM should stabilize and extend back toward pre-pandemic levels by mid- to late-2021. The clear risk to our forecast is around the size of the next fiscal package. Any package larger than our estimate of 1-1.5trn USD would require larger coupon auction sizes in the months ahead. However, while there is scope for yields to gradually move higher, COVID and election uncertainty will likely keep bond yields capped over the medium term.

Weighted average maturity of marketable debt outstanding

Months

Source: U.S. Treasury Department, J.P. Morgan Asset Management.

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