Government Bond Issuance Boom to Pressure Yields Higher

Ballooning Fiscal Deficits

Governments around the globe will need to boost their sovereign debt issuance to pay for ballooning fiscal deficits, largely as a result of their COVID-era policies. A lot of private sector leverage moved to the government balance sheet. Now the debt collector is at the door.

The US deficit is likely to end 2023 at about 6% of gross domestic product (GDP), while the UK deficit will probably be more than 5% of GDP.¹ Total government debt-to-GDP ratios in the UK and the US are already at or near 100% and could easily go higher, while the debt-to-GDP ratio in traditionally profligate fiscal spender Italy is over 120%.² This has come at a time when the biggest buyers of bonds—global central banks—are stepping away. Many central banks are in the midst of quantitative tightening. More recently, the Bank of Japan similarly started stepping away from yield curve control, which is the last significant quantitative easing-like program in the world.

The US is also shifting the composition of its new Treasury issuance away from short-term bills and into longer-term “coupon” supply as the T-bills issued after the resolution of the debt ceiling mature. Coupon issuance should account for about 39% of net Treasury supply this year before rising to approximately 86% in 2024.³ With the yield curve still very inverted, longer-term yields will need to move meaningfully higher to entice buyers away from the attractive short-term rates.

As a result of these supply dynamics, much of the action could move to the long end of yield curves, while in 2022 shorter‑term yields were more volatile as curves sharply inverted. The two‑year US Treasury yield increased 370 basis points (bp) last year, while the 30-year Treasury yield “only” climbed 207 bp. German government yields followed a similar course, with the two-year yield rising about 335 bp (from deeply negative territory at the end of 2021) and the 30-year bund yield increasing only 62 bp.⁴

This should result in a “twist” in yield curves, with long-end rates most likely increasing and curves steepening. In 2011, the Federal Reserve purposely targeted lower long-term yields in “Operation Twist” by selling short-maturity Treasuries and buying longer-end securities. Today, however, I think that we may be entering a period where central bank actions don’t have much effect on long-term rates because of the distortions caused by the flood of supply.

Expect fleeting rallies before rates peak

I have been fully expecting some rallies that temporarily push yields lower as we wait for our indicators that we’ve reached a peak in rates to turn green. While these yield decreases could be meaningful and enticing, I anticipate waiting for one of these signposts to appear before I would advise strategically adding duration.

Also, I am convinced that yield curve segmentation will lead to most of the eventual rally in duration taking place at the shorter end of the yield curve. Given the recent tightening of financial conditions, growth is likely to slow, benefiting shorter maturities. But the flood of upcoming longer-term government debt supply will probably keep yields at the long end of the curve more elevated. So whether or not we have seen the peak in yields, yield curves will steepen over time in a move that could be led by either end of the curve.