Supply And Demand Are Still Alive And Well

Treasury auctions may face weaker demand but they’re still getting done

Insider

Contributing Writer

Mortgage rates, Treasury security prices, lakefront properties, Ford Pintos, rare stamps, oil … the list of things whose prices are determined by supply and demand is immense. We mention this because Treasury auctions, used to help finance the U.S. Government (along with taxes), have become quite a hot topic and are impacting lenders. And since the prices of mortgage-backed securities, and therefore mortgage rates, are in part calculated as a spread off of U.S. Treasury securities, the supply and demand of these are important to lenders and their borrowers.

As 2023 progressed, the sizes of these auctions were rather large, particularly for a period of time when we were not in a crisis. The appetite for newly issued Treasury bonds has been waning due to a few large buyers scaling back their purchases, and this, in turn, impacts the auction results and makes investors sit up and notice. If no one wants to buy something that must be sold, the price will drop until someone buys it.

In the case of Treasury securities, when prices drop, yields go up. The industry saw a rise in interest rates throughout 2022 and 2023 until mid-December. As rates rise, so do Treasury yields and coupons on newly issued debt, which increases the expense burden on the federal government and mortgage rates in general.

Although the Treasury auctions have been met with weaker demand, they’re still getting done. And the U.S. is still the most credit-worthy country in the world, so a default or material deterioration seems highly unlikely, not to mention politically disastrous. The three big historical buyers of U.S. Treasury securities (the Federal Reserve, Japan, and China) have reduced their purchases. In fact, the Federal Reserve has become a net seller of fixed-income securities.

Treasury Catalyst

The primary reason for the Fed turning into a net seller of Treasurys was its quantitative tightening program, intended to reduce the size of the Fed’s balance sheet and fight inflation, which began in mid-2022. Recall that in 2020 and 2021, the Federal Reserve stepped in to buy securities, pushing prices higher and rates lower. No more.

This shift had been well-publicized through speeches and communication from the Fed. Still, it was the catalyst that drove Treasury yields higher starting in the summer of 2022, with the 10-year yield going from a yield of .5 percent to about 3.5% and then to 5% in 2023.

That is the “demand side” of the equation. On the supply side, the amount of debt the U.S. needed to issue started rising in late 2020 to cover COVID-related fiscal stimulus. This carried forward into 2023. The increasing amount of debt that needs to be absorbed without the three primary buyers of U.S. debt is concerning. That said, there is a back-up plan whereby Primary Dealers absorb (buy) whatever isn’t bought by other bidders in a Treasury auction.

It is not the role of anyone in capital markets to predict where rates are going and base their hedging activities on any predictions.

Primary Dealers are active in every Treasury auction that takes place. Because there has been less demand from other buyers, the primary dealers have had to absorb an increasing amount of issuance. They, in turn, will sell their holdings to other parties such as insurance companies, pension funds, and money managers. But if the U.S. Treasury auctions continue to become weaker, they could serve as a catalyst for yields to rise again, or at least not drop as much as they could, creating a less friendly environment for stocks and pushing the U.S. interest expense higher.

Debt Bellwether

Unlike the issuance of mortgage-backed securities (MBS), Treasury auctions are scheduled, the amounts known in advance, and there are few surprises until the results are announced. However, these results are a bellwether for general debt market conditions. Since MBS trade as a spread to Treasuries, their prices will react. MBS prices will always be lower and rates higher than the corresponding Treasury maturities due to credit and prepayment (early pay off) risk, but they do move together.

For this reason, the capital markets staff of lenders watch the results of the Treasury auctions to ascertain the general appetite and climate of the debt markets. If the demand is flagging, rates may tend to move higher, and lenders may make their mortgage pricing slightly less aggressive than otherwise.

Of course, it is not the role of anyone in capital markets to predict where rates are going and base their hedging activities on any predictions. Any thoughts about the general rate climate must be balanced against where a lender wants to be in a competitive position, as well as covering the company’s overhead and managing the capacity/ability to fund loans.