Bond Issuance vs. Fiscal Deficits (Mechanics)
The relationship between:
- fiscal deficits
- bond issuance strategies (by the fiscal government to cover these deficits), and
- market dynamics…
…has significant implications for bond yields, asset prices, and the broader economy.
Adjustments in these strategies can either support or strain liquidity in the market, influencing economic activity and trader/investor behavior.
In fact, it can elongate economic cycles, cause money to flow into cash and riskier assets at the same time, among other unique factors that we’ll discuss in this article.
Let’s look at some summarized concepts:
- Upward Pressure on Bond Yields: When there are factors such as quantitative tightening and large government budget deficits, without likely adequate demand for the debt, there is bearish pressure on bond yields. The base expectation is that the combination of these factors would lead to higher interest rates.
- Treasury’s Response: Instead of increasing net bond issuance in response to these pressures, the Treasury (advised by the Treasury Borrowing Advisory Committee (TBAC)) can opt to fill the funding gap with T-bills and by spending cash on hand. This decision can counteract the expected impact of the liquidity drain by adding extra bonds (i.e., what’s called “duration”) to the market and provide support to asset prices and the economy.
- Impact on the Economy: The reduced net bond issuance, especially during a period of rising fiscal deficits, means that the deficit-funded money in the real economy does not need to be absorbed by long-term Treasury bonds (by that money buying bonds). Instead, it can be funded with short-term T-bills. This dynamic increased the amount of money available for long-duration and risky financial assets, providing support to both the economy and markets.
- Shift in Issuance Strategy: The Treasury’s strategy of issuing more short-term debt (T-bills) and less long-term debt helped to avoid putting upward pressure on interest rates and pulling money out of riskier assets. However, this can’t be done forever.
- Future Implications: As bond issuance begins to rise to approach a level more consistent with the large federal budget deficit, the dynamics that have supported liquidity in the past are expected to change. This could lead to reduced liquidity in the market, potentially impacting asset prices and economic activity.
- Treasury’s Decision-making: The Treasury aims to issue debt in a manner that doesn’t disrupt the bond market significantly. They typically adjust their issuance strategy based on demand and other economic factors. However, with changing economic conditions, adjustments in bond issuance become market-moving events.
Treasury Issuance & Market Dynamics
The Federal Reserve reducing its balance sheet and growing its fiscal deficits without adequate demand for the bonds would cause a rise in interest rates.
Contrary to expectations, this pressure doesn’t always materialize as anticipated.
Historically, the Treasury’s bond issuance moved in tandem with the budget deficit, meaning that during economic downturns, when bond issuance was high (lots of stimulus spending and lower tax receipts), there was also more money available to purchase these bonds.
This made the bond market relatively stable and predictable.
However, shifts in macroeconomic factors can make the Treasury’s bond issuance decisions more impactful.
For instance, while the Federal Reserve was reducing its balance sheet in 2023-24, the Treasury opted to issue more T-bills instead of bonds.
This decision was made despite a growing budget deficit, which typically would necessitate more bond issuance.
The Treasury’s strategy was to maintain a consistent gross issuance, leading to a decline in net bond issuance (we cover this more in the FAQ section of this article).
This approach effectively countered the anticipated liquidity gap (i.e., not enough demand for the bonds), as the increased budget deficit injected money into the economy faster than it was being absorbed by bond issuance.
Another significant factor was the rise of T-bill issuance, which was easily absorbed due to the presence of a large repo facility (also covered in the FAQs).
The Treasury’s bond issuance, however, will need to slowly increase due to:
- larger budget deficit
- need to satisfy market demand not have short-term debt overtake the market
When the factors that maintain high liquidity levels rapidly change, it can have implications for the bond market and the broader economy.
Why Money Can Flow into Cash and Stocks at the Same Time
Expectations are normally that when you get rising short-term interest rates, it leads to increased risk premiums and reduced liquidity as money moves from assets to cash.
In a market scenario like 2023, while there was a significant flow into cash, surpassing expectations, liquidity remained high.
This unusual scenario, where both cash and equities saw inflows, resulted from the Treasury issuing T-bills instead of bonds as the Fed reduced its balance sheet.
Despite a significant need for government financing, the Treasury maintained a steady gross issuance, leading to a decline in net bond issuance.
This was due to the Treasury’s issuance schedule not aligning with actual needs.
As the Fed issued fewer bonds amidst a larger budget deficit, money flowed into the real economy faster than it was being absorbed by bond issuance.
The rise in T-bill issuance was easily absorbed due to a big drawdown in the repo facility.
Treasury’s Role in Filling the Liquidity Gap
The Treasury’s strategy of issuing more short-term debt worked well in filling the liquidity gap, which prevented pressure on rates and riskier asset prices.
However, that’s unlikely to be sustainable.
The declining net issuance occurred during a period of a rising fiscal deficit, which is unusual.
The deficit wasn’t absorbed by long-term Treasury bonds but was funded with T-bills.
The funding for these T-bills didn’t come from the deficit but shifted from other cash sources, particularly a large repo facility set up by the Fed.
As T-bill rates aligned with or exceeded the repo facility, money transitioned from the repo facility to T-bills.
This allowed for deficit funding without pulling money out of the real money (people buying bonds instead of other goods, services, and other financial assets), increasing the money available for long-duration and risky assets.
To summarize the last two sections:
Summary
Essentially, the Treasury helped fill the liquidity gap by:
- issuing more short-term debt that could easily be absorbed by inert cash sources and…
- …less long-term debt that would have…
- …put upward pressure on interest rates and pulled money out of riskier assets (because all assets compete with each other for investor dollars and because higher rates reduces credit creation and overall liquidity in the economy).
How This Can Elongate the Economic Cycle
As the Fed tightens and short-term interest rates rise, the economy usually faces challenges from increased savings rates and money moving from financial assets to cash, leading to lower asset prices and a negative wealth effect.
However, the discussed dynamic prevented these adverse effects, providing support to both the economy and markets during that period.
For an extended period, the budget deficit has been larger than the bond issuance, leading to more money circulating in the real economy relative to issuance – i.e., money that has to be pulled back out (which would come with higher interest rates in the event the market doesn’t clear at prevailing rates).
This contributed to the strength of the real economy, as the deficit’s impact is amplified due to less of it being absorbed by bond issuance.
How Does the Treasury Decide to Issue Bonds (Long-Term Debt) vs. Bills (Short-Term Debt)?
The Treasury aims to minimize its impact on the bond market.
Typically, they maintain a consistent issuance calendar, adjusting gradually to economic shifts.
For instance, during unexpected events like Covid-19, they initially issued more T-bills, avoiding immediate changes to their calendar.
Over time, they would then increase bond issuance and decrease T-bill issuance.
The Treasury targets a balance where gross T-bills constitute 15% to 20% relative to bonds.
However, this isn’t a strict range, and discussions about exceeding it have occurred.
The primary objective isn’t economic stimulation but rather to prevent market disruptions by avoiding drastic changes in the bond issuance calendar.
However, due to economic changes, the Treasury sometimes has to make adjustments.
These adjustments, especially if unexpected, can influence market movements.
The trend suggests a reduction in T-bill issuance and an increase in bond issuance to catch up and maintain the desired balance.
Treasury’s Strategy: Balancing Market Impact and Satisfying Bonds Buyers with Optimal Funding Costs
The Treasury conducts surveys to gauge demand and ensure they issue debt where there’s the most demand on the yield curve in a way to optimize funding costs.
While there’s significant T-bill demand, they maintain a conservative approach to avoid potential roll problems and other technical issues.
Their strategy also involves eliminating issuances with low demand (for example, the 7-year bond hasn’t traditionally had high demand in the US, nor has the 20-year relative to the 10-year and 30-year issuances).
A recent buyback announcement aims to remove low-liquidity bonds and reissue in areas with high liquidity.
The overarching goal is to minimize debt costs by targeting areas with natural demand.
Are These Issues Likely To Be Increasingly Important Dynamics In Markets Going Forward?
In a world where fiscal and monetary policies are closely linked, the relationship between quantitative tightening and Treasury issuance has become more significant than in the past.
The dynamic covered in this article can explain the unusual scenario where money flows into both cash and equities simultaneously.
The Treasury knows that T-bill issuance can’t take over the whole debt market (and be funded by inert cash sources) and bond issuance being behind the deficit isn’t sustainable.
FAQs – Bond Issuance vs. Fiscal Deficits
What is the difference between gross bond issuance and net bond issuance?
Gross bond issuance refers to the total amount of bonds issued by a government or institution within a specific period, without considering any bonds that mature or are repaid during that time.
Net bond issuance, on the other hand, takes into account the bonds that mature or are repaid.
It’s the difference between the gross bonds issued and the bonds that are no longer outstanding.
Fiscal deficits are funded by bond issuance. If a government issues T-bills, it pays them off in one year or less. If it issued T-bills because it didn’t have money, where does it get the money to pay off the T-bills?
Governments typically repay T-bills using revenues from taxes, fees, and other sources of income.
If those revenues are insufficient, the government might roll over the debt by issuing new T-bills or other securities to raise the necessary funds.
Essentially, they borrow new money to pay off old debt.
This is a common practice and can be sustainable as long as the government can manage its debt levels and there’s demand for its securities.
There are also quantitative easing (QE) programs where the central bank literally buys it with money it creates. But QE is run only sometimes.
How can the repo facility absorb bond issuance?
A repo (repurchase agreement) facility allows financial institutions to sell securities, often government bonds or T-bills, to another party with an agreement to repurchase them at a later date, usually the next day, at a specified price.
This acts as a short-term loan.
Central banks, like the Federal Reserve, use repo facilities to regulate liquidity in the financial system.
When the central bank conducts repo operations, it provides cash to financial institutions in exchange for their securities, effectively absorbing those securities temporarily.
This can help absorb bond issuance because financial institutions can purchase bonds or T-bills and then use them in repo transactions with the central bank, ensuring there’s demand for the newly issued bonds or T-bills.
So the repo facility is like a buffer?
Yes, the repo facility acts as a buffer or a safety valve for the financial system.
By allowing financial institutions to temporarily exchange securities (like bonds or T-bills) for cash, the repo facility provides short-term liquidity to the market.
This ensures that financial institutions have access to the necessary funds to meet their short-term obligations, even if they are holding onto longer-term assets like government bonds.
In this way, the repo facility helps stabilize the financial system and ensures smooth functioning of the money markets.
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