Behind "big and beautiful" is "big and fierce"? Short-term US Treasury bonds will face a flood of supply.

Written by: Wall Street Journal

Original Title: "The Big and Beautiful Act" Passed, Will the U.S. Open a "Supply Flood" of Short-Term Treasury Bonds?

With the formal implementation of the Trump administration's large-scale tax cuts and spending bill, the U.S. Treasury may unleash a "supply flood" of short-term government bonds to make up for future fiscal deficits of several trillion dollars.

The market has begun to respond to future supply pressures. Concerns about an oversupply of short-term government bonds have been directly reflected in prices—the yield on one-month short-term government bonds has risen significantly since this Monday. This marks a shift in the market's focus from earlier concerns about the sell-off of 30-year long bonds this year to the front end of the yield curve.

trillion deficit looming, the U.S. short-term Treasury market is set to face a "supply flood"

The implementation of the new bill first brings a severe expectation for future fiscal conditions. According to the nonpartisan Congressional Budget Office (CBO), the bill is projected to add up to $3.4 trillion to the national deficit in the fiscal years 2025 to 2034.

Faced with huge financing needs, issuing short-term government bonds has become a choice that combines cost-effectiveness with the preferences of decision-makers.

First of all, from a cost perspective, although the current yield on short-term government bonds with a maturity of one year or less has risen to over 4%, it is still significantly lower than the issuance rate of nearly 4.35% for ten-year government bonds. For the government, at a time when interest expenses have become a heavy burden, a lower instant financing cost is enough to create a strong attraction.

Secondly, this aligns with the clear preference of the current government. Previously, President Trump himself expressed a preference for issuing short-term bills rather than long-term bonds. Treasury Secretary Mnuchin also stated to the media that increasing the issuance of long-term bonds at this juncture "makes no sense."

However, this strategy is not without risks. Relying on short-term financing may expose borrowers to fluctuations in future financing costs or higher risks. An anonymous Canadian bond portfolio manager stated:

"Any time you finance a deficit with very short-term securities, there is a risk of a shock occurring that could put financing costs at risk."

For example, if inflation suddenly rises and the Federal Reserve has to consider raising interest rates, then as Treasury bond yields increase, the cost of short-term financing will also rise. Additionally, economic recession and shrinking economic activity may lead to a reduction in savings, thereby decreasing the demand for short-term bills.

Supply and Demand Showdown: Can 70 trillion in liquidity absorb the bond issuance surge?

The supply gate is about to open wide, and the market's absorption capacity has become a new core issue. Currently, the market seems to be confident, and this confidence stems from the massive liquidity accumulated in the monetary market.

First, let's look at the supply side. Currently, the Treasury Borrowing Advisory Committee (TBAC) of the U.S. Department of the Treasury recommends that the short-term Treasury securities should account for about 20% of the total outstanding debt. However, the interest rate strategist team at Bank of America predicts that to absorb the new deficit, this percentage could soon rise to 25%. This means that the market needs to be prepared for a supply of short-term securities that far exceeds the official recommended level.

The market's focus has thus dramatically shifted. Just in April and May of this year, investors' anxiety was still concentrated on the selling spree of 30-year long-term government bonds and the risk of their yields soaring above 5%. Now, however, the spotlight has completely turned to the other end: will short-term government bonds trigger new turmoil due to oversupply?

On the demand side, Matt Brill, North American Investment Grade Credit Head at Invesco Fixed Income, believes that the nearly $7 trillion in money market funds in the market is showing a "persistent demand" for front end debt, and the U.S. Treasury seems to recognize this as well.

Mark Heppenstall, President and Chief Investment Officer of Penn Mutual Asset Management, is more optimistic, stating:

"I don't think the next crisis will come from short-term government bonds. There are many people looking to get capital moving, especially when real yields look quite enticing. You might see some pressure on short-term bond rates, but there is still a significant amount of cash flowing in the market.

If there really is a problem, the Federal Reserve will find a way to support any supply and demand imbalance.