The steady rise in long-term Treasury yields has attracted plenty of investor attention. But short-term bills are starting to draw focus for the opposite reason: Some could fall below zero in coming weeks if policy makers don’t act.
Yields on some Treasury bills—short-term securities that mature in a year or less—could temporarily turn negative because of a coming supply crunch, experts say. While they won’t be auctioned by the U.S. at rates below zero, as auction rules prevent that, bills could trade at negative yields in secondary markets.
That is notable because the Federal Reserve has indicated it doesn’t intend to cut rates below zero; while its policy rate is expected to stay positive, other interest rates may not. The last time bill yields fell below zero was in March 2020, during a record-breaking scramble for cash by companies and investors looking to ensure they had enough liquidity to survive the steep slowdown in economic activity caused by Covid-19. The Fed responded to that crisis by easing policy, reviving bond-buying efforts, and introducing several new lending programs.
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Markets look very different today than they did in the early days of the pandemic, however. And if some interest rates do turn negative again, the drivers behind that move will be very different as well.
Still, while any negative rates would be the result of technical and likely temporary market pressures, they highlight how difficult it is for investors to earn returns in fixed-income markets. What’s more, many investors are exposed to potential negative rates through money-market fund holdings that are still near record levels.
The biggest force driving rates lower is the Treasury Department’s preparations to shrink its near-record cash holdings before the reinstatement of the debt ceiling in August. Officials recently announced plans to run down the Treasury’s cash balance to $800 billion by the end of March. It recently had about $1.6 trillion in cash, according to Federal Reserve data, after the Treasury stepped up debt issuance significantly in response to the pandemic and was left with excess cash on hand.
So starting this week, officials plan to stop selling certain types of bills that saw ramped-up issuance last year to finance the Cares Act. That would reduce bill issuance by as much as $60 billion per week, according to strategists at Wrightson ICAP, though they expect the Treasury to partly offset that reduction by increasing the size of sales of bills at other maturities.
“We expect these continuous [bill] paydowns to happen really until the middle of this year,” said Peter Yi, director of short duration fixed income and head of taxable credit research for Northern Trust Asset Management, in an interview with Barron’s. “The magnitude of this paydown is really extreme.”
Another factor driving interest rates’ move lower is a change in the way government-sponsored enterprises Fannie Mae and Freddie Mac are allowed to invest their cash, according to Bank of America. They must invest in short-term markets backed by government securities rather than mortgage-backed securities, the bank wrote. The strategists said that policy change, along with declines in bill supply, could drive interest rates to zero in the market for repurchase or repo agreements, where big financial institutions pledge Treasuries in exchange for cash.
Put simply, the implication for investors is this: Large institutions will have fewer places to park their cash short term, and that will weigh down short-term yields across financial markets unless, or until, policy makers act.
That matters because investors of all types have been more enamored with cash than one might expect during the past six months’ rally in stocks and risky corporate debt.
While investors have withdrawn $14 billion from money-market funds since the end of September, according to the Investment Company Institute, that leaves $4.3 trillion in money-market funds, not too far from their record high of $4.8 trillion last year. And more of that cash is in government bond markets than it has been historically, after U.S. regulators changed rules for money-market funds to address risks that surfaced during the financial crisis.
The crunch in short-term yields leaves investors with even fewer options, as stocks trade at record highs and high valuations, and as long-dated government and corporate bonds face higher risk of paper losses with long-term Treasury yields rising.
There are a few different ways U.S. policy makers can take action and head off interest rates staying too low for too long, however.
The first and most obvious would be for Congress to lift the debt ceiling. The Treasury likely wants to extend the maturity of its financing no matter what, but without the restriction officials could reduce short-term bill issuance more gradually, and put less pressure on the market for short-term rates in the process. Lawmakers could also pass a new stimulus bill to deploy more of the cash the Treasury has on hand, strategists say.
The Fed can also act to ensure that a wider range of short-term interest rates stay above zero. Strategists at Bank of America think the Fed will respond by tweaking the interest rate it pays on banks’ excess reserves, or raise the interest rate that money-market funds and other institutions can earn by pledging cash overnight in exchange for Treasuries from the Fed’s balance sheet. Officials have also discussed expanding the size of that overnight lending program to manage short-term interest rates, according to meeting minutes from November.
Yi, of Northern Trust Asset Management, also believes that the Fed will take action to boost short-term rates if they fall below zero.
“This technical adjustment could be the tide that lifts all boats higher, and should even lift T-bill [yields] and prevent negative interest rates on those really short instruments,” he said. “That’s just better for the market, in terms of its functioning.”
But isn’t clear when either of those steps will occur. So until then, investors may want to be even more wary of cash than usual.
Write to Alexandra Scaggs at [email protected]
