What’s Ahead For US Interest Rates?

In early February, the U.S. Treasury made a statement that has not received much attention even though what it implies regarding their thoughts on the future demand for treasury securities (and hence yields) is very interesting. The announcement was mainly about the auction of $72 billion of coupon securities, but it also said that it plans to issue a final rule on floating-rate notes in the coming months, with the first FRN auction expected to occur within the next year. The statement probably did not get a lot of attention because theTreasury has spoken about the idea of floating-rate notes earlier too. However, it had never given a specific time frame in the past. This is significant, not just because it will be first new type of treasury security to be issued since 1997 when the U.S. government introduced TIPS or Treasury inflation-protected securities, but also because what the need for the Treasury to issue these at this time implies about their view on interest rates.

The details on the floating rate notes still need to be worked out. Treasury hasn’t chosen the index to use, and is considering the Treasury 13-week bill auction high rate, Treasury general collateral overnight repurchase agreement rate, etc. All of these will make Treasury’s financing cost variable and expose it to the risk of higher costs in future if the index moves higher.

At a time when yields are low, what is the need to introduce a new security that can result in higher costs as rates increase?  The only reason to introduce something that may result in higher cost for debt is the worry that there may not be enough buyers for fixed rate Treasury debt once yields start increasing. With trillion dollar budget deficits and need to refinance maturing debt, if there are not enough buyers, the lower demand will naturally result in yields moving higher quickly.

How much will rates move?

There is almost universal expectation that yields are going higher. Numerous reports and articles over the last few months have mentioned expectations of higher yields and concerns about the risks to investors holding fixed rate debt from various market participants (examples:  Barron’sBank Of AmericaPIMCO,  Financial Times).

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