Across the Curve

Refunding Thoughts

The highlight of the trading session today was the announcement by the Treasury of the February refunding package and in concert with that the changes in the auction cycles necessitated by the financial crisis and recession.

The Treasury did announce that they will auction $32 billion 3 year notes, $21 billion 10 year notes and $14 billion Long Bonds next week. That package is in line with street estimates.

What was not in line was the profile of the new 7 year note which will be auctioned at the end of this month. Most street analysts had anticipated that there would be a 7 year note and it would be issued quarterly. The Treasury opted for a monthly 7 year note. The private sector Treasury Borrowing Advisory Committee has recommended that the new note should be auctioned for $15 billion at its initial offering at the end of the month.

The issue will be sold in concert with the 2 year note and the 5 year note. This will be an interesting endeavor for the taxpayers. Let us assume that the Treasury holds the size of the 2 year note and 5 year note offerings constant. That is a rather weak assumption in this environment but last month they were $40 billion and $30 billion respectively. When you add the new 7 year on top of that you find that the street will be bidding on $85 billion of coupon supply at the end of each month.

In the report of the advisory Committee they suggested that the Treasury should bump up the 2 year note to $45 billion and the 5 year to $40 billion from $30 billion.

The committee also recommended an increase in the monthly 3 year note and 10 year note cycle.  They suggested that they 3 year note be increased to $35 billion from the current $30 billion. The total issuance of 10 year notes in the most recent cycle was $52 billion Comprised of auctions of $20 billion initially and followed by reopenings of $16 billion each.

The Treasury also announced that it will issue Long Bonds eight times per year, up from the current quarterly issuance. They will sell a bond in February, May, August and November and then reopen each of those bonds in the following month.

The Treasury averred that it would consider monthly bond issuance at the next refunding in May.

This is a staggering amount of supply which will need higher yields to attract buyers. The yield curve is steepening as we speak to accommodate supply and I think that we have only begun to see the initial workings of that process.

Some analysts have suggested that as the 10 year rate moves above 3.00 percent that will force the hand of the Federal Reserve and it will necessitate that august institution’s purchases of long dated Treasury debt.

I wonder if the people who suggest that are ensconced in a bit of a financial twilight zone. When rational investors view the enormity of the requirements of the Treasury, I think that they will view the entrance of the Federal Reserve into the mix as a force for inflation and a Ponzi scheme which would make even Mr Madoff smile.

I am not sure how this plays out but I think it means higher yields and a much steeper yield curve for any instrument beyond 5 years.