Treasury plays the hand it’s dealt

Fast on the heels of intervention in support of a falling Japanese yen, Treasury Secretary Scott Bessent made it clear this week that he is willing to actively address the recent run-up in long-term interest rates. The announced increase in long-term Treasury purchases within the existing Treasury buyback program signals that Bessent does not want long-end yields to rise much more and is willing to use his tools to attempt to address the situation.

The move suggests the US Treasury is doing their version of an Operation Twist—historically the selling of short-term and buying of long-term bonds to twist the yield curve in order to lower borrowing costs—since the additional long end buybacks will be funded by issuing more bills.

The immediate market reaction made sense as the news likely prompted some steepener unwinds by institutional investors. But as day two progressed, yields retraced mostly to pre-announcement levels.

Since the US is still issuing heavy amounts of new debt to fund the large deficit, this “twist” potentially alters the mix of debt enough to affect the yield curve, but the big deficit and need to borrow persist. Left unaddressed are the bigger problems, namely the structural deficits and record amounts of cumulative outstanding debt and interest costs. Add in the competition for capital from the massive long-term issuance by high quality “hyperscalers” plus the deficit and inflation implications of the Iran war, and one can see why the modifications to the Treasury buy-back program have had little lasting impact so far.

With the immediate market reaction already subsiding, the doubling of long-end US Treasury buybacks may only be the opening moves in a potentially longer effort that would include participation from the Federal Reserve (Fed).

As for the Fed, its direct control is largely limited to the overnight policy rate. Longer maturity Treasury yields increasingly reflect expectations over higher inflation (concerns elevated on the geopolitical risks and continued pressure on energy prices), economic growth, Treasury issuance and term premium. Over the last several years, rising deficits, growing debt levels and concerns about inflation persistence have pushed risk premiums and real yields higher. Questions surrounding Fed independence also have not helped. As a result, changes in Fed policy do not necessarily transmit one-for-one to the 10-year Treasury yield.

In theory, if policymakers wanted to implement some form of yield curve control, the Fed could purchase longer-dated Treasuries to place downward pressure on 10-year yields. Mechanically, this would resemble quantitative easing and would require expanding the Fed's balance sheet. The challenge is that such an approach appears inconsistent with the stated preference of Chair Warsh and many policymakers to continue reducing the size of the Fed's balance sheet.

In addition, there is a reasonable argument that aggressively cutting the Fed funds rate without corresponding improvements in inflation or fiscal dynamics could have the opposite effect on the long end of the curve. If investors interpreted such cuts as inflationary or fiscally accommodative, 10-year and longer Treasury yields could move higher rather than lower as term premium increased.

This brings us back to Secretary Bessent’s goals. His focus has been on the 10-year Treasury yield rather than the Fed funds rate and his "3-3-3" framework seeking to achieve:

• 3% real GDP growth;
• A budget deficit reduced to 3% of GDP; and
• An increase in domestic energy production equivalent to 3 million additional barrels per day

The logic is straightforward: stronger growth, lower fiscal deficits, and lower energy-driven inflation should collectively reduce inflation expectations and term premium over time, allowing the 10-year yield to settle at a lower level. It is not the logic that is the problem, it is the lack of a credible plan to simultaneously achieve all of the above.

Treasury's issuance strategy can also play a role at the margin. Recently, Treasury has leaned more heavily on bill issuance rather than significantly increasing coupon issuance. That may modestly reduce pressure on longer maturities, but we would characterize the impact as incremental rather than transformational. Treasury cannot sustainably engineer a much lower 10-year yield simply by altering the mix of bill versus coupon issuance.

Ultimately, getting the 10-year Treasury to 4% or below in a durable fashion likely requires some combination of lower inflation, a smaller deficit and continued growth.  Alternatively, of course, a recession where the Fed cuts rates rapidly could also ameliorate inflation concerns and lower nominal yields, but that is not the preferred outcome.

Read more about our current views and positioning at Fixed Income Perspectives