With the passage of the “Big and Beautiful Act”, will the United States start a “supply flood” of short-term Treasury bonds?

Written by: Wall Street News

As the Trump administration's massive tax cuts and spending bill is officially implemented, the U.S. Treasury may start a "supply flood" of short-term Treasury bonds to make up for the trillions of dollars in fiscal deficits in the future.

The market has begun to respond to future supply pressures. Concerns about oversupply of short-term Treasury bonds have been directly reflected in prices - the yield on 1-month short-term Treasury bonds has risen significantly since Monday. This marks that the market focus has completely shifted from concerns about the sell-off of 30-year long bonds earlier this year to the front-end interest rate curve.

With trillion-dollar deficits weighing on the market, the U.S. short-term Treasury bond market will face a "supply flood"

The implementation of the new bill first brought about a grim expectation of future fiscal conditions. According to the nonpartisan Congressional Budget Office (CBO), the bill will increase the US national deficit by up to $3.4 trillion between fiscal years 2025 and 2034.

Faced with huge financing needs, issuing short-term government bonds has become an option that is both cost-effective and preferred by decision-makers.

First, from the perspective of cost, although the current yield of short-term government bonds with a term of one year or less has climbed to more than 4%, it is still significantly lower than the issuance rate of 10-year government bonds, which is close to 4.35%. For the government, at a time when interest expenses have become a heavy burden, lower spot financing costs are enough to constitute a strong attraction.

Secondly, this is in line with the clear preference of the current administration. Previously, US President Trump himself has expressed his preference for issuing short-term notes rather than long-term bonds. Finance Minister Bessant also told the media that it "doesn't make sense" to increase the issuance of long-term bonds at the current node.

However, this strategy is not without risk. Relying on short-term funding could expose borrowers to the risk of volatile or higher funding costs in the future. An anonymous Canadian bond portfolio manager said:

“Any time you finance a deficit with very short-term paper, there is a risk of a shock that could put funding costs at risk.”

For example, if inflation suddenly rises and the Fed has to consider raising interest rates, short-term financing costs will increase as Treasury yields rise. In addition, a recession and a contraction in economic activity may lead to a decrease in savings, thereby reducing the demand for short-term bills.

Supply and demand showdown: Can 7 trillion liquidity absorb the peak of bond issuance?

The supply gates are about to open, and the market's ability to absorb the supply has become a new core issue. At present, the market seems to be confident in this, and its confidence comes from the huge amount of liquidity accumulated in the money market.

Let's look at the supply side first. Currently, the U.S. Treasury Borrowing Advisory Committee (TBAC) recommends that the upper limit of short-term Treasury bonds to total outstanding debt is about 20%. However, Bank of America's interest rate strategists predict that this ratio may soon rise to 25% to absorb the new deficit. This means that the market needs to be prepared for a supply of short-term bills that far exceeds the official recommended level.

The market's focus has shifted dramatically. As recently as April and May this year, investors' anxiety was focused on the sell-off of 30-year Treasury bonds and the risk of their yields soaring to more than 5%. Now, the spotlight has completely shifted to the other side: Will short-term Treasury bonds cause new turmoil due to oversupply?

On the demand side, Matt Brill, head of North American investment-grade credit at Invesco Fixed Income, believes that there is a "continuous demand" for front-end debt from the $7 trillion in money market funds in the market, and the U.S. Treasury seems to be aware of this.

Mark Heppenstall, president and chief investment officer of Penn Mutual Asset Management, is more optimistic.

“I don’t think the next crisis is going to come from short-term Treasuries, there are a lot of people who want to put capital to work and real yields look pretty attractive. You may see some pressure on short-term Treasury rates, but there is still a lot of cash flowing in the market.

If problems do arise, the Fed will find ways to provide support for any supply-demand imbalances.”