Global Rates Notes: May 2022 Refunding Recap

·Treasury announced across the curve cuts to nominal auction sizes in its May refunding announcement, surprising against our expectation for more targeted reductions at longer maturities. The broader cuts appear to have been supported in part by stronger-than-expected tax receipts, which imply a lower FY22 deficit than our assumption.

·A structural shift lower in the deficit trajectory could mean further auction size cuts, though the most likely outcome is auction sizes will stabilize following the current round. These reductions will leave auction sizes within $3-to-6bn of pre-Covid levels despite higher overall gross financing needs, and the issuance mix appears poised to shift quite heavily towards bills by early next year.

Treasury announced a third round of across-the-curve reductions to fixed rate nominal auction sizes at its May refunding meeting. The cuts were broad based when compared to our pre-refunding projections, as Treasury cut 2s, 3s, and 5s (each by $1bn per month) where we had expected no change at these maturities. Additionally, the $2bn per month reduction in 7y issuance exceeded our expectation of $1bn per month, while adjustments to 10s, 20s, and 30s were in line with our projections (Exhibit 1). Our view had been one of somewhat targeted cuts to 7s through 30s, but the historically large mid-April tax receipts appear to have created room for adjustments across the curve, with Treasury noting that the stronger year-to-date tax receipts had reduced its FY22 deficit assumption by about $250bn. Cumulatively these cuts reduce gross fixed rate nominal supply from $780bn per quarter to $723bn.

Looking ahead, Treasury left open the door to further reductions if the deficit outlook were to warrant them. For now, however, there is uncertainty around whether this year’s elevated tax collection is a one-off or a more structural shift. There are reasons to suspect it is the former—the biggest surprise has come from non-withheld receipts, and a strong contribution from capital gains taxes (rather than more reliable withheld tax receipts) seems to be the most likely driver. Further, the latest round of cuts have taken auction sizes to within $3-6bn of pre-Covid levels despite higher overall gross financing needs. The issuance mix for the coming years also looks poised to shift quite heavily towards bills, in part to meet increasing financing needs from Fed runoff. Under our projections, net bill supply would still be negative in the current calendar year (with a paydown of about $105bn), but the current quarter would mark the low point, with net bill issuance poised to rise to $750bn in 2023 (Exhibit 2). Therefore, we think further auction size reductions are unlikely, except in the event that we are wrong in our deficit assumption.

In the near term, our baseline above still implies a meaningful bill paydown over the remainder of Q2 and roughly flat bill supply in Q3. April already saw negative bill supply of about $100bn, and even under Treasury’s more generous $800bn cash balance target for end-Q2, we expect another $300-$350bn drop in bills outstanding in May and June combined. This would push the bill share to the bottom of the 15-20% range than Treasury has indicated it will seek to maintain over time (Exhibit 3), likely adding to downward pressure on funding spreads. We do not think that these localized pressures warrant projecting additional coupon size cuts however, as the bill supply outlook for 2023 should allow for a rise in the bill share to the middle of the target range. Further, another round of incremental auction size cuts would do very little to open up space for more bill supply in the near term. In our view, allowing for a larger temporary overshoot in the TGA would be a more effective way to smooth through some of the volatility in bill supply, if Treasury were so inclined.

In the near term, our baseline above still implies a meaningful bill paydown over the remainder of Q2 and roughly flat bill supply in Q3. April already saw negative bill supply of about $100bn, and even under Treasury’s more generous $800bn cash balance target for end-Q2, we expect another $300-$350bn drop in bills outstanding in May and June combined. This would push the bill share to the bottom of the 15-20% range than Treasury has indicated it will seek to maintain over time (Exhibit 3), likely adding to downward pressure on funding spreads. We do not think that these localized pressures warrant projecting additional coupon size cuts however, as the bill supply outlook for 2023 should allow for a rise in the bill share to the middle of the target range. Further, another round of incremental auction size cuts would do very little to open up space for more bill supply in the near term. In our view, allowing for a larger temporary overshoot in the TGA would be a more effective way to smooth through some of the volatility in bill supply, if Treasury were so inclined.

Outside of nominal space, Treasury’s signals on TIPS issuance were largely consistent with our expectations. We expect Treasury will remain open to further increases in 5s and 10s, but decisions beyond this year will be significantly informed by how market conditions evolve amid a shifting demand picture and high inflation uncertainty.