Written by: Wall Street Journal

With the Trump administration's massive tax cuts and spending bill officially in place, the U.S. Treasury may open the "supply flood" of short-term Treasuries to offset future trillions of dollars in fiscal deficits.

The market has begun to react to future supply pressures. Concerns about an oversupply of short-term Treasuries are directly reflected in prices — the yield on one-month short-term Treasuries has seen a significant rise since this Monday. This marks a complete shift in market focus from earlier sell-off worries over 30-year long bonds to the front end of the interest rate curve.

Trillion-Dollar Deficit Pressures, U.S. Short-Term Treasury Market Set to Face a 'Supply Surge'

The passage of the new bill first brings a grim expectation for future fiscal conditions. According to estimates from the nonpartisan Congressional Budget Office (CBO), this bill will add up to $3.4 trillion to the national deficit for the U.S. between fiscal years 2025 and 2034.

Faced with immense financing needs, issuing short-term Treasuries has become a choice that balances cost-effectiveness and the decision-makers' preferences.

First, from a cost perspective, current yields on short-term Treasuries with a maturity of one year or less have risen above 4%, but remain significantly lower than the nearly 4.35% issuance rate of ten-year Treasuries. For the government, lower immediate financing costs are a strong attraction given that interest expenses have become a heavy burden.

Furthermore, this aligns with the current administration's clear preference. Previously, President Trump himself expressed a preference for issuing short-term bills rather than long-term bonds. Treasury Secretary Yellen also stated to the media that increasing long-term bond issuance at this juncture "makes no sense."

However, this strategy is not without risks. Relying on short-term financing may expose borrowers to future fluctuations in financing costs or higher risks. An anonymous Canadian bond portfolio manager stated:

"At any time when you finance a deficit with extremely short-term bills, there is a risk of shocks occurring, which could put financing costs at risk."

For example, if inflation suddenly rises and the Federal Reserve has to consider raising interest rates, then as Treasury yields increase, short-term financing costs will also rise. Moreover, recession and shrinking economic activity may lead to reduced savings, lowering demand for short-term bills.

Supply and Demand Showdown: Can $7 Trillion in Liquidity Absorb the Bond Issuance Surge?

The supply gates are about to swing wide open, and the market's absorption capacity has become a new core issue. Currently, the market seems confident, drawing strength from the immense liquidity accumulated in the money market.

Looking first at the supply side. Currently, the Treasury Borrowing Advisory Committee (TBAC) recommends that the proportion of short-term Treasuries to total outstanding debt should be capped at around 20%. However, Bank of America's interest rate strategist team predicts that to absorb the new deficit, this proportion may soon rise to 25%. This means that the market needs to be prepared for a supply of short-term bills that far exceeds the official recommended levels.

As a result, the market's focus has dramatically shifted. Earlier this year, in April and May, investor anxiety was concentrated on the sell-off of 30-year long-term Treasuries and the risk of their yields soaring above 5%. Now, the spotlight has completely turned to another end: will short-term Treasuries experience new turmoil due to oversupply?

On the demand side, Matt Brill, head of North American investment-grade credit at Invesco Fixed Income, believes that the $7 trillion in money market funds in the market presents a "persistent demand" for front-end debt, which the U.S. Treasury also seems to recognize.

Mark Heppenstall, President and Chief Investment Officer of Penn Mutual Asset Management, is even more optimistic, stating:

"I don't think the next crisis will come from short-term Treasuries. Many people want to get capital moving, especially when real yields look quite enticing. You may see some pressure on short-term Treasury rates, but there is still a lot of cash flowing in the market."

"If there are really problems, the Federal Reserve will find ways to support any supply-demand imbalances."