• During the 1st year of the pandemic the Federal budget deficit grew from 5% to 19.5% of GDP
  • During the past year, the budget deficit has fallen from 19.5% of GDP to 7.5%
  • Fed buying absorbed 85% of Treasury issuance during the 1st year of the pandemic, 67% in the 2nd year
  • As the Fed commences to reduce the size of its balance sheet, the Treasury issuance coming onto the market could actually grow even as the budget deficit contracts. 

Long-term U.S. Treasury yields have risen by more than 100 basis points (bps) over the past few months spurred by a tight labor market, rising inflation, the prospect of higher short-term interest rates, and balance sheet shrinkage by the Federal Reserve (Fed). These factors appear to have dampened demand for U.S. Treasuries as investors seek assets that offer some combination of inflation protection or greater potential for capital growth. Despite their recent rise, U.S. Treasury yields remain low by historical standards and are just now reaching levels not seen since 2018 (Figure 1).

Figure 1: Treasury yields have risen sharply, but levels are still historically low

While much of the attention has focused on the aforementioned factors that influence demand for U.S. Treasuries, the supply picture for U.S. Treasuries has been evolving rapidly in ways that are easily overlooked.  For starters, the U.S. budget deficit has been shrinking rapidly, from 19% of GDP one year ago to around 7.2% today (Figure 2).  This implies a great deal less U.S. Treasury issuance than we have seen over the past few years of the pandemic period.

Figure 2: The U.S. budget deficit expanded from 5% to 19.5% of GDP before shrinking to 7.5%

The decline in the U.S. budget deficit has come as COVID-related support programs have begun to expire. From 2014 to 2020, Federal spending rose slightly from 19% to 20.5% of GDP. Once the pandemic struck, Federal spending jumped to 35% of GDP as the U.S. government attempted to insulate tens of millions of Americans from the economic hardships brought about by pandemic-related restrictions on economic activity.

In the past 12 months, however, government spending has fallen from 35% to 25% of GDP as many of these support programs have expired (Figure 3). Once all the programs have been allowed to run their course, Federal spending may come back to around 21% or 22% of GDP, slightly higher than pre-pandemic levels, owing to the $1 trillion boost to infrastructure spending that will be spread out over the next five years.

Figure 3: Federal spending rose from 21% to 35% of GDP before falling back to 25% of GDP

Tax revenues were volatile in 2020 but began to rise sharply in 2021.  As the employment market rebounded, and as wages began to grow rapidly, personal income tax revenue rose from 8% to 10% of GDP.  Additionally, corporate profits surged in 2021 as well, which contributed to a near doubling of revenue from the corporate income tax from 0.9% of GDP in 2020 to 1.7% of GDP in 2021.  Revenue from payroll and other taxes remained stable during the past year but might begin to grow as employment rebounds (Figure 4). 

Figure 4: Personal and corporate tax revenues have expanded by 3% of GDP over the past year

Typically, when supply increases in markets, prices fall, and when supply decreases, prices rise.  Since, by definition, bond yields move in the opposite direction as their price, an increase in Treasury supply should, in theory, send prices lower and bond yields higher.  By contrast, a reduction in Treasury issuance ought to have the opposite effect, supporting bond prices and helping ease yields down to lower levels. 

Curiously, at the beginning of the pandemic, the opposite appears to have occurred. During the first 12 months of the pandemic, bond yields plunged as the U.S. budget deficit grew from 5% to nearly 19% of GDP.  During the second year of the pandemic, bond yields rose substantially even as the budget deficit shrank by nearly two thirds.  There appear to be two confounding factors that explain this phenomenon:

  1. During the first year of the pandemic, inflation remained stable at around 2%, falling in H1 2020 as commodity prices fell and then rebounding as commodity prices recovered.  During the second year of the pandemic, however, inflation surged to over 8%, putting upward pressure on bond yields despite the shrinking of budget deficits and the attendant reduction in the pace of new debt issuance.
  2. The Federal Reserve (Fed) bought $3 trillion of debt securities in March, April and May 2020, and then proceeded to buy an additional $120 billion per month as part of its quantitative easing (QE) program.  During the pandemic’s first year, the Fed bought $4 trillion of debt, or about 17% of GDP worth of government bonds, mortgages and corporate debt.  This absorbed over 85% of the Treasury’s issuance of new debt.  During the pandemic’s second year, the Fed tapered the pace of its purchases, buying an additional 5% of GDP worth of debt or about 70% of the new Treasury issuance.  As such, the amount of Treasury-issued securities finding their way into the markets didn’t change as much between the first and second years of the pandemic as the change in the size of the budget deficit would have implied on its own (Figure 5).  

Figure 5: During the pandemic the Fed absorbed a great deal of the additional Treasury issuance

The Fed has indicated its intention to begin reducing the size of its balance sheet at a pace of $47.5 billion per month through August and then shifting to $95 billion per month after that.  Given this two-stage projected pace of balance sheet reduction, the net amount of U.S. Treasury debt supply coming onto the public markets would likely equal the size of the budget deficit +4% (or so) of GDP. 

There are both active and passive approaches to the Fed shrinking its balance sheet.  Active balance sheet reduction involves selling securities into market, and the Fed plans suggest they want to minimize this approach.  Passive balance sheet reduction involves allowing debt securities to roll-off as they mature and no longer using the proceeds to purchase securities as the Fed was doing previously.  The Fed also receives substantial interest income from its debt portfolio, and the Fed can also choose not to re-invest its interest income in new securities.  Finally, the Fed still has some loan outstanding from its Pay Check Protection and Main Street Lending programs that may be repaid and not re-invested.  All of these techniques for balance sheet reduction would have the same end result: less debt on the Fed’s balance sheet and more debt to be absorbed by the public sector.

Balance sheet reduction is not without precedent.  In 2018 and 2019 as the Fed engaged in its first ever round of quantitative tightening, the amount of Treasury debt coming onto the market exceeded the size of the U.S. budget deficit (Figure 6).  Such a scenario could play out again later this year and in 2023 if the Fed follows through on its balance sheet reduction even if it does so passively by allowing bonds to roll into maturity without using the proceeds to make new purchases further up the yield curve. 

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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