Report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee

October 29, 2024

Letter to the Secretary

Dear Madam Secretary,

Since the TBAC last met in late July, 2-year Treasury yields have declined about 30 basis points following the Federal Reserve beginning policy rate reduction with a 50 basis point decrease in September. 2-year yields had declined to as low as 3.5% and 10-year yields to 3.6% after jobs reports in July and August showed a rising unemployment rate and slowing payroll employment. But a stronger jobs report in September led yields to rise leaving 10-year yields at 4.25%, roughly unchanged from late July. Treasury markets are likely to remain sensitive to job market data, Federal Reserve policy expectations, and market expectations for the upcoming US election and fiscal policy.

A string of softer inflation readings contributed to the shift in market and Federal Reserve official attention away from upside risk to prices and toward downside risk to employment. Three-month annualized core PCE inflation peaked at 3.7% in April but slowed to 2.0% in August. The slowing in inflation has been broad across both goods and services. Shelter inflation remains stubbornly elevated, but slowing new rents and generally softer demand in housing has markets and Federal Reserve officials expecting a further slowing in this category.

Economic activity has continued to advance at a solid pace, largely supported by consumer spending. Diffusion indices indicate that while the services sector is expanding, the manufacturing sector is in contraction. Housing activity has softened with existing home sales for September falling to the lowest level since 2010. The effects of Hurricanes Helene and Milton are likely to distort labor market and activity data, making it more difficult than usual to deduce the underlying strength of the economy.

With inflation risks having diminished, Treasury markets have become more sensitive to labor market data. Through mid-September data pointed toward a more-rapid-than-expected softening in labor markets. On August 21st, the BLS released preliminary benchmark revisions indicating that total nonfarm employment had been overestimated by 818k as of March 2024 - implying job growth had been overstated by about 68k per month. The unemployment rate rose to 4.25% in July and remained at 4.22% in August, with payroll employment slowing to a pace that might not be sufficient to keep the unemployment rate from rising further. Low hiring and quit rates, anecdotal accounts that firms have scaled back hiring, and more individuals reporting that jobs are "hard to get" in the Conference Board survey also raised concern that labor markets might weaken more significantly. On the other hand, JOLTS and jobless claims show layoffs remain subdued.

As labor market concerns rose in early August, expectations for a more rapid pace of Federal Reserve easing led to a brief period of heightened market volatility as levered trades were unwound. The US dollar depreciated relative to other currencies and implied equity volatility spiked as "carry trades" premised on the interest rate differential between the US and other countries were exited. The dollar depreciation was particularly sharp with respect to the Japanese Yen as the Bank of Japan was viewed as more likely to raise interest rates.

In the September jobs report, released in early October, the three-month average pace of job growth accelerated to 186k and the unemployment rate dropped back to 4.05%. Markets rapidly reassessed the risks to the outlook leading Treasury yields to rise and the US dollar to strengthen.

Much of the variation in Treasury yields over the intermeeting period can be attributed to shifting expectations of relative central bank policy. The shifting balance of risks led the Federal Reserve to cut policy rates by 50bp in mid-September and interest rate markets priced approximately 75bp of additional cuts over the year. But following stronger jobs and activity data released following the FOMC meeting, the market is now implying an additional 45bp of cuts over the remainder of the year.

In addition to near-term policy expectations, longer-end yields are also sensitive to expectations for the Federal Reserve's "terminal rate" and fiscal deficits. The Treasury yield curve has steepened significantly with the 10-year yield to 2-year yield differential rising from -50 basis points in June to +15 basis points in October. The recent rise in longer-term Treasury yields largely represents a rise in the "term premium" according to the ACM term structure model.

In light of this fiscal backdrop, the Committee reviewed Treasury's November 2024 Quarterly Refunding Presentation. Based on the estimates published on October 28, Treasury currently expects privately-held net marketable borrowing of $546bln in Q1 FY 2025 (Q4 CY 2024), with an assumed end-of-December cash balance of $700bln. The borrowing estimate is $19bln lower than what was projected in July. For Q2 FY 2025 (Q1 CY 2025), privately-held net marketable borrowing is expected to be $823bln, with a cash balance of $850bln projected at the end of March, assuming enactment of a debt limit suspension or increase.

The median primary dealer estimate of privately-held net marketable borrowing needs in FY 2025 and 2026 increased by $128b since July. The Committee observed that the newly released FY 2027 primary dealer deficit projections are notably higher than OMB and CBO estimates, driving higher forecasts of privately-held net marketable borrowing by primary dealers in that fiscal year. Committee members also noted that the CBO and OMB rate forecasts from summer 2024 are lower than current market forward implied rate levels. The Committee also discussed the significant uncertainty around the potential path of deficit. While we expect to have incremental clarity next quarter, there is room for continued deviation from these estimates.

The Committee appreciated Treasury's update on their primary dealer meetings, taking particular interest in the feedback on TIPS issuance patterns. In general, primary dealers noted stronger demand for front-end TIPS, which corroborated historical work done by the group. We would welcome the opportunity to explore this further.

The Committee reviewed the feedback on buybacks, noting that the impact continues to be modestly supportive of liquidity, including from cash management buybacks. The group valued the additional metrics shared on buyback operations and discussed possible drivers of the purchase results in various buyback buckets.

The Committee then moved to discuss the first charge: the Inter-Agency Working Group on Treasury Market Surveillance's (IAWG's) efforts on Treasury market resilience. By and large, the charge analysis found the IAWG's efforts to be supportive of market functioning and liquidity, though highlighted the difficulty of attribution in light of other factors such as the net expansion of the Federal Reserve's balance sheet since 2019. The work also highlighted areas of meaningful evolution in the Treasury market in recent years:

• Large structural deficits leading to rapid Treasury market growth
• Dealer intermediation capacity has not kept pace with issuance
• Increasing size of money market funds
• Increased Federal Reserve intervention
• Shifting preferences of reserve managers and asset managers
• Rise of non-traditional investor types

While much of this is well known, the Committee felt that the rise of principal trading firms and specifically the growth in passive index investing could warrant further exploration. In aggregate, these shifts prompted five possible policy suggestions to consider, most of which are focused on increasing intermediation capacity and enhancing Treasury market resilience. Specifically, the IAWG could consider additional initiatives such as centrally clearing the Standing Repo Facility, various ways of exempting Treasuries from the supplementary leverage ratio and putting a greater focus on risks generated by month-end spikes in trading volumes.

The second charge focused on digital assets and the impact on the Treasury market. Growth in digital assets has been significant, though impact to Treasury markets has been muted as of yet. Initial intersectionality is likely to continue to be in demand for short-end Treasuries, to support growth in stablecoins. As institutions further evolve in their use of digital assets, the Committee felt that, on balance, this could drive additional hedging demand for US Treasuries.

The charge also explored tokenization of US Treasuries (and other assets). While this could facilitate enhanced operational and economic efficiency, the legal and regulatory infrastructure would need to evolve meaningfully, with strong official sector oversight. Additionally, technological and financial stability related risks would need to be considered. As noted in the charge, the way forward should involve a cautious approach spearheaded by a trusted central authority, with widespread buy-in from private sector participants.

In terms of issuance for the upcoming quarter, the Committee recommended that Treasury keep nominal coupon auction sizes unchanged. Turning to TIPS, the Committee supported increasing the 10y TIPS auction by $1bln (and the $1bln increase of the reopening of the 5Y TIPS in December). For FY2025 Q2 (CY2025 Q1), the Committee provisionally recommended unchanged nominal coupon sizes, with a $1bln increase to the February 30y TIPS, noting significant uncertainty.

Away from economic events, the Committee emphasized the risk that debt limit constraints could hamper the efficient funding of the government at the lowest possible cost to the taxpayer. These episodes can cause significant economic uncertainty, affect financial markets, and impact US credit ratings. As noted in letters written both as part of the Quarterly Refunding process, but also independently in 2011, 2016, 2021, and 2023^[1], lack of resolution of the debt limit runs the risk of undermining the foundation of the US Treasury market.

Respectfully,

Deirdre K. Dunn

Chair, Treasury Borrowing Advisory Committee

Mohit Mittal

Vice Chair, Treasury Borrowing Advisory Committee

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