A massive $1 trillion in Treasury bonds is going to flood the bond market

Interest rates may be in for triple whammy that drives them even higher, according to one top researcher at Bank of America. First, there was the Federal Open Market Committee’s rate-rising effort to battle inflation, which may yet continue; now, with a debt-ceiling deal in place, the Treasury is expected to release a large quantity of bonds to make up for lost time. Then there’s the fallout from both of those decisions, and how it could affect corporate spreads.

“There is uncertainty that investors will demand compensation for,” Mark Cabana, Bank of America’s head of US rates strategy, told CFO Brew. Combining all of these factors, he added, “suggests that credit spreads front-end will face challenges.”

How much are we talking about? “I would expect that corporate credit spreads will be widening marginally, maybe five to 10 basis points,” Cabana said, noting that BofA’s analysis assumes that the Fed won’t raise rates, the Treasury will flood the markets with around $1 trillion in short-term issuances this summer, and that Treasury securities will rise “another 10 to 20 basis points,” according to Cabana.

Overall, it’s not a huge effect for corporate borrowers, but Cabana thinks corporations should be planning for the uncertainty implied. “The magnitudes that we’re talking about are not necessarily game-changer quantities, if you’re a corporate [borrower], but they are additional headwinds that may not have been fully anticipated by the corporate community, and they may find that they need to pay up and be more aggressive in order to have their debt taken down,” Cabana said.

For corporate borrowers who’ve navigated rocky terrain over the past 12 months, there might be a temptation to slow down and see what comes next. But BofA’s advice to borrowers is to speed it up: “We’ve been telling them that you want to try and issue early in advance; you don’t want to fight against the Treasury supply surge,” Cabana said.

High supply. Fundamentally, the influx of treasuries that’s coming is “a rising risk-free tide that lifts all boats,” as Cabana puts it. And it’s not going away: “The supply surge is a level shift; it’s not a temporary phenomenon,” Cabana explained, adding that “in our view the US deficit is only going one way and there was supply that was held back as a result of the debt limit, and now the supply floodgates are open.”

Considering all forms of government debt, in addition to corporate issuances and mortgages, Cabana said he believes the bond market is coming to a situation where, “when we look at the supply backdrop, at least on the Treasury side, it’s daunting,” and that on the other side of the market, “we are uncertain where the demand will come from.”

Overshoot your shot? With the feedback loop of increasing issuances amid an environment in which the Fed has been using interest rate hikes to head-off inflation, “it raises the risk that there may be an overshoot at some point.”

Ultimately, that overshoot is the only real opportunity Cabana sees for demand to meet supply in the bond market—because the only large buyer he believes can put a cap on this market is the Federal Reserve, if it determines that markets have grown too tight. That would be a problematic scenario, in which “you would need to see a pretty sharp and meaningful deterioration in market functioning.”