How Fitch downgrade might impact Treasury’s $1 trillion third-quarter borrowing plans

Earlier this week, Treasury released a $1.007 trillion borrowing estimate for the third quarter that is the largest ever for that time frame, raising questions about the extent to which foreign and domestic buyers can continue to keep up their demand for U.S. government debt. It’s not just demand that’s been of concern, but also the risk that higher funding costs could, in turn, exacerbate the government’s fiscal deficit.

In 2011, when Standard & Poor’s downgraded the U.S.’s credit rating to AA+ from AAA, investors counter-intuitively flocked to Treasurys for safety. That experience, which left many in financial markets unscathed, may be helping to mitigate the fallout of Tuesday’s decision by Fitch. The timing of Fitch’s move “was a surprise, but drew attention to an ongoing deterioration in the fiscal trajectory” that many already knew about, according to Steven Zeng, a New York-based strategist at Deutsche Bank
DB,
-2.45%.

While Fitch’s downgrade is “a negative for sure, the fallout from the 2011 downgrade was pretty limited,” Zeng said via phone on Wednesday.

Over the next couple of weeks or months, “if the equity market shakes this off, yields probably move higher because of concerns about increased Treasury issuance,” he told MarketWatch. “If the equity market thinks this is somehow the straw that breaks the camel’s back because it disrupts market functioning or economic growth — and it sells off — yields could actually decline on greater safe-haven demand for Treasurys.” That demand could even help to offset any impact from higher funding costs in the future, according to Zeng.

See also: $25 trillion Treasury market is in the spotlight as U.S. loses its AAA rating for a second time

Some of the financial market’s concerns about upcoming issuances were acknowledged in materials released by the Treasury on Wednesday.

In a letter to U.S. Treasury Secretary Janet Yellen, Deirdre Dunn and Colin Teichholtz, respectively the chair and vice chair of the Treasury Borrowing Advisory Committee, wrote that wrangling over the U.S. debt ceiling earlier this year “imposed a direct cost on taxpayers through higher borrowing costs for the U.S. Treasury.” After Congress reached an agreement to suspend the debt ceiling, “focus shifted to Treasury’s plans to rebuild its cash balance, with some concern that the increased T-bill issuance and liquidity drain might lead to volatility or market disruption.”

Those concerns have failed to materialize so far, however. Now, “attention has shifted to more generalized profitability concerns that may continue to worsen with funding rates higher, shift in financial regulation, and an inverted yield curve over time compressing net-interest-margins,” they wrote.

While demand for Treasury issuance remains strong, “the Committee felt that the seven- and 20-year segments may not bear increases as well as other points on the curve,” Dunn and Teichholtz said. This is the case even as “T-bills have proven to be an effective absorber of unexpected issuance needs, and the Committee expects that can continue given current levels of demand.”

At UBS Global Wealth Management, Solita Marcelli, chief investment officer for the Americas, and others said that “we continue to advise investors to buy quality bonds, including U.S. government bonds, which offer attractive all-in yields and the potential for capital appreciation if investors start to worry about slowing growth.” In addition, they wrote in a note, “we prefer five- to 10-year maturities, and our forecast is for the 10-year yield to reach 2.75% by June 2024 from around 4% at present.”

While Fitch’s decision might be expected to push yields higher on U.S. government debt as investors demand a greater risk premium, Marcelli and others pointed to the 2011 experience and said that “based on historical experience and current economic conditions, we expect yields to fall, and we view U.S. government bonds as most preferred.”

On Wednesday, all three major U.S. stock indexes DJIA SPX COMP finished lower, with the tech-heavy Nasdaq Composite suffering sharp losses, after stock investors were rattled by Fitch’s decision. Meanwhile, 10-year
BX:TMUBMUSD10Y
and 30-year Treasury yields
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ended at almost nine-month highs as fixed-income traders also focused on Wednesday’s better-than-expected private-sector employment report for July.

In Wednesday’s refunding announcement, Treasury unveiled its plans for August. It said it is offering a total of $103 billion of Treasury securities next week via auctions of $42 billion in 3-year notes, $38 billion in 10-year notes, and $23 billion in 30-year bonds.

The rest of Treasury’s financing requirements over the quarter are expected to be met with regular weekly bill sales, cash management bills, and monthly note, bond, Treasury Inflation-Protected Securities, and 2-year Floating Rate Note auctions. And further gradual increases in auction sizes “will likely be necessary in future quarters,” officials said.

“The strength and resilience of the U.S. economy is providing a constructive backdrop for Treasury’s increased issuance. There is still strong demand for the safe haven asset that is U.S. Treasurys,” said Van Hesser, chief strategist at Kroll Bond Rating Agency in New York.

In a phone interview, Hesser said that “if people are feeling better about the U.S. economy, that demand is going to show up. If things were to deteriorate, whether it’s the U.S. fiscal situation or the economy, that demand could fluctuate. But the more important factor is that people are feeling better right now about the resilience of the U.S. economy.”