Debate on US Treasuries: Will Increased Issuance Dilute the Interest Rate Cut Benefits?

The expectation among some investors that a deceleration in inflation will lead the Federal Reserve to cut interest rates in the near future could bolster the U.S. bond market. However, another segment is apprehensive about the impending surge of Treasuries issuance, with concerns over the fiscal health of the US federal government.

Bullish investors anticipate the late 2023 surge in bond markets to extend into the current year, contingent on the Fed's expected easing of monetary policy.

Although the US CPI rebounded slightly in December, economists predict that inflation is likely to fall again in January and may be below 3%. This suggests that the Fed do not have to restrict demand growth as much as they once thought.

Yesterday's retail data somewhat tempered expectations for rate cuts, but data from the Fedwatch tool indicates that the probability of a rate cut in March stands at 61%, with a 93% chance of a rate cut by May.

Since mid-2022, the Federal Reserve has shrunk its balance sheet by more than $1 trillion, reversing the extensive bond-buying spree implemented during the 2020 pandemic onset.

Last week, JPMorgan analysts indicated that an unexpected conclusion of quantitative tightening may enhance the supply-demand dynamics in the Treasury market by reducing the volume of government bonds offloaded onto the private sector.

Concerns among some investors that US Treasury issuance might nearly double to $2 trillion by 2024 could potentially act as a balancing factor. These worries contributed to pushing Treasury prices down to their lowest point in 16 years during the height of anxiety in October.

"There's really an outrageous amount of US Treasury supply coming from the lack of fiscal discipline in this country, and we don't necessarily see who the buyers are," said Chris Diaz, portfolio manager and co-head of fixed income at Brown Advisory.

According to Bloomberg data, the 10-year U.S. Treasury RSI has recently approached 70, a signal indicative of overbought conditions. This suggests the possibility of a short-term retracement.

JPMorgan points out that the market's expectations for US long-term inflation have markedly decreased, suggesting that there is still room for Treasury bonds to appreciate in the long term. However, short-term fluctuations are anticipated, with recent trends pointing a peak has been reached. Should the equity rebound observed in November and December be attributed to a sharp fall in Treasury yields, such a rally might also pause.

Some investors maintain that the bond market may have already factored in anticipated rate cuts, implying that a shift in expectations for future rate reductions could introduce greater complexity, potentially exerting downward pressure on bond prices.

Tony Roth, Wilmington Trust's Chief Investment Officer, pointed out that persistent inflation could reduce the appeal of bonds by diminishing the purchasing power of their returns. This could prompt investors to reallocate funds to alternative asset classes, potentially rendering the bond market more vulnerable.