The U.S. Treasury is facing a bit of a quandary: It needs to issue more debt, yet it is coming up against the start of ‘operate balance sheet reduction’ by the Federal Reserve. As such, it would like to have a good idea as to how much of an impact the balance sheet normalisation will have on demand for its debt and, in turn, the shape of the yield curve. As the Fed’s demand for treasuries diminishes, the Treasury will have to replace that ‘somewhat less interest rate sensitive’ source of demand, with volume and duration that will appeal to private investors—both banks and nonbanks. Accurately gauging the level of demand will be crucial if it is to avoid any sharp (but likely short-term) changes in the shape of the curve.
It was anticipated that the Treasury’s intentions would be deduced from this week’s major quarterly refunding announcement. However, the Treasury (having done its homework through a detailed set of questions posed to its primary dealers) chose to play it safe for now and maintain this quarter’s issuance at last quarter’s levels. This means that the markets now have to wait until the November announcement (after the expected start of balance sheet normalisation) for a better idea as to how the Treasury will respond to the Fed’s balance sheet normalisation. How this balance sheet reduction process is likely to be carried out and what potential impact it is likely to have on interest rates is a key question for both investors and the Treasury; we attempt to shed light on how this could play out in this week’s Economics Weekly.
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Richard de Chazal, CFA is a London-based macroeconomist covering the U.S. economy and financial markets.