Don't Sleep On What's Happening In The Bond Market

The U.S. Treasury recently expanded a program to buy back some of its own long-term bonds. It sounds counterintuitive: Why would the government buy bonds while simultaneously issuing more of them?

The answer makes more sense if we start with a few building blocks.

Terminology

A Treasury security is essentially an IOU issued by the U.S. government, allowing it to borrow money from investors in exchange for interest. The interest paid on Treasuries is called its yield. Short-, intermediate-, and long-term Treasury yields tell us what rates investors require to lend money to the U.S. government for different lengths of time.

Throughout this discussion, when we refer to short- or long-term interest rates, we're generally talking about Treasury yields, the benchmark rates that influence borrowing costs throughout the economy.

Why and how does the government borrow?

When the federal government spends more than it collects in taxes, it runs a budget deficit. Treasury finances that gap by borrowing money from investors. The basic cycle looks like this:

Why have long-term interest rates increased?

Persistent deficits mean the Treasury must continually sell enormous amounts of debt. Historically, it has had little trouble getting investors to buy it. But now, concerns over inflation, government spending, and declining liquidity are making investors less interested in buying government bonds.

This creates supply and demand problems.

The supply of new Treasuries is ever-increasing as the government continues to borrow to fund its deficits. If fewer people want to buy those bonds, the Treasury has to sweeten the deal by paying higher interest.

Meanwhile, many older Treasury securities trade less frequently and can become harder to buy and sell. Why would an investor buy an old bond paying 2.5% when they can buy a new bond paying 5%? They wouldn't unless they can buy the 2.5% bond at a discount. This difficulty in selling bonds quickly without taking a price hit is described as declining liquidity. This liquidity risk further reduces demand for Treasuries and, again, forces the government to pay higher rates to entice investors.

With Treasury yields serving as the benchmark for borrowing costs throughout the economy, these higher yields don't just affect Washington. Higher long-term interest rates are tied to higher mortgage rates, higher corporate borrowing costs, more expensive business investment, greater interest expense, and potentially slower economic growth.

For households, that can mean more expensive mortgages, auto loans, and other credit. For businesses, projects that made sense when financing cost 4% may no longer make sense when it costs 7%. That can eventually influence hiring, investment, and business growth.

What is the Treasury attempting to do?

On August 19, the Treasury announced it will at least double its buybacks of older 10–30- year Treasuries, calling these "liquidity support" buybacks. They are essentially going into the market to buy back the old Treasury bonds people can't sell at full price, increasing liquidity. The hope is that improving liquidity will allay investors' concerns so they will accept lower interest rates to buy its debt.

Of course, to buy back its old, long-term debt, the government has to issue new debt to pay for it. They intend to fund that by issuing short-term Treasuries (bills and notes) rather than new long-term bonds.

This does nothing to reduce the government's debt; it just changes how it is financed. It shifts some of the debt from long-term to short-term.

Short-term debt is typically less expensive than long-term debt. That's logical - I would charge you less to borrow money for a week than I would to borrow it for a year. So, shifting to more short-term debt financing could reduce the amount the government pays in interest on its debt in the near term.

Think of it like refinancing a 30-year fixed mortgage to an adjustable-rate mortgage (ARM). At least initially, the interest rate is lower on the ARM than the 30-year fixed mortgage, so refinancing reduces expenses in the immediate term. But when the fixed-rate period ends, the ARM rate will adjust, either higher or lower. If rates go up, the money you saved in the beginning may be wiped out by the higher costs you pay in the future.

The Treasury faces a similar choice between locking in long-term rates with long-term Treasury bonds and borrowing for shorter periods using Treasury bills. They might save money on interest in the near term, but there is risk in locking in rates for shorter periods.

What could this mean?

For bond investors, higher rates are a mixed bag. Existing bond prices generally fall as rates rise, but new bonds offer more attractive yields.

For households and businesses, higher Treasury yields tend to ripple through the economy with higher mortgage and corporate borrowing costs, less spending and investment, and potentially slower economic growth.

The federal government has the same problem. As older debt matures, it must increasingly be refinanced at today's higher rates. The more it costs to pay interest on the debt, the more it has to borrow, creating larger deficits, more borrowing, and higher rates. More money devoted to interest also means less available for government programs without additional taxes or borrowing.

Conclusion

The Treasury's current strategy has two distinct goals.

First, clean up the bond market, buy older, harder-to-trade bonds, improve liquidity, and hopefully reduce the extra yield investors demand.

Second, manage new borrowing, avoid flooding the market with too much long-term debt, potentially rely more on shorter maturities, keep near-term financing costs manageable, and accept greater refinancing risk later. It is an attempt to manage a very large and growing pool of debt more efficiently.

Thus far, the impact of the Treasury's liquidity buyback plan was noticeable, but short-lived. After a brief reduction in long-term Treasury yields, investors quickly returned their attention to inflation, deficits, and the enormous amount of government borrowing still required, and rates quickly increased again.

This demonstrates that investors help determine what it costs the government, and the rest of us, to borrow. While the Fed certainly has significant influence, especially over short-term rates, if deficits remain large, investors could continue demanding higher yields on long-term Treasuries. That could mean that we experience higher interest rates in the future, not because the Fed increases them, but because investors demand them.