Wave of U.S. Treasury Issuance Puts Pressure On Bond Market | Prometheus Macro

Episode Summary

Executive Summary: Ahan Menon argued that the U.S. economy has avoided recession so far because tight policy hasn’t fully translated into private-sector pain: low locked-in borrowing costs, large cash-like asset holdings, and strong nominal income have muted net interest expense. But he expects duration-heavy Treasury issuance, continued QT, and sticky inflation to tighten financial conditions enough to trigger a recession around Q2 2024, with stocks and bonds both vulnerable and long bonds likely the eventual winner in a true downturn.

Main Topics: Why recession has been delayed (Priority: 5/5): Menon says this hiking cycle is unusual because private-sector net interest expense has not risen enough, thanks to low-rate legacy debt and large holdings of cash-like assets that earn the short rate. Liquidity as the key macro variable (Priority: 5/5): He defines liquidity as the flow of cash and cash-like assets that support spending, emphasizing that system-wide liquidity depends on both existing balance-sheet risk and new risk being issued. Treasury issuance and duration risk (Priority: 5/5): A major focus is the Treasury’s shift toward issuing more coupons/longer-duration debt, which he thinks will be poorly absorbed and force higher yields, asset sales, and lower liquidity. Market implications for stocks and bonds (Priority: 4/5): He expects both stocks and bonds to weaken as liquidity tightens, with stocks outperforming bonds tactically until the economy clearly rolls over; in a real recession, long bonds should ultimately outperform. Inflation outlook remains sticky (Priority: 4/5): Menon argues inflation will not fall to target quickly because shelter is cooling but transport, food, services, and auto-related dynamics remain resilient, leaving core inflation above levels implied by fed funds pricing. Credit and spending transmission (Priority: 4/5): He stresses that the Fed must slow new financing and leveraged spending to reduce nominal income, savings/consumption dynamics, and eventually employment, which is how inflation ultimately breaks. Prometheus Macro’s research approach (Priority: 2/5): The firm provides systematic macro research and quant portfolios aimed at democratizing institutional-level tools for investors across equities, fixed income, and commodities.

Key Arguments: The current cycle is delayed because rising policy rates have not fully hit the private sector through net interest expense; many borrowers are still benefiting from low fixed-rate liabilities and income on cash-like assets. Money market funds and reverse repo balances created a large pool of cash-like liquidity that supported spending and absorbed Treasury bill issuance, but this buffer is less able to absorb new coupon/duration supply. Treasury coupon issuance is likely to pressure markets because traditional buyers—levered hedge funds, banks, and cash investors—face weak incentives or constraints to take on more duration. The Treasury’s rising duration supply is a liquidity drain because it injects risk and volatility into the system, forcing asset sales elsewhere and pressuring both yields and risky assets. Stocks have outperformed bonds because liquidity conditions, nominal GDP, and growth expectations have improved relative to bearish expectations, but that outperformance may reverse as issuance and tightening bite. Core inflation is likely to stay above market-implied expectations because shelter disinflation alone will not be enough; transport and services can keep inflation elevated. The Fed may keep rates high for longer than recession bulls expect because officials will not cut decisively until inflation is clearly and durably near target. A true recession/bond bull requires not just slowing growth but clear disinflation, layoffs, and a sustained decline in inflation toward 2%; brief recessionary weakness is not enough. Private-sector liquidity matters as much as official liquidity: corporate profits, issuance, repo, and financial intermediation can expand risk-taking even when bank deposits decline. The eventual regime shift is from a 60/40-friendly environment to one where cash and short-duration assets are more attractive until growth and inflation fully roll over.

Data Points: Recording date: August 30 - Conversation took place before early-September publication. Fed policy rate: 5.5% - Used as the current level of interest rates in the discussion. Expected durable downturn in real GDP: Starting around March 2024 - Menon’s base case if policymakers stay tight on liquidity and rates. Treasury coupon issuance: About $380 billion over the next two quarters - He cited this as a large increase relative to recent history. Income benefit from money market funds: Close to 2% of GDP - Estimated ballast to nominal spending from cash-like assets earning the short rate. Core PCE inflation forecast: 3.4% to 3.6% by mid-2024 - He argued this would be inconsistent with the cuts priced into markets. Monthly core inflation estimate: About 30 bps per month - His median estimate, implying roughly mid-3% inflation annually. Fed funds futures pricing: About five cuts - He said markets were pricing cuts that would fit a recession and sub-2% inflation, which he does not expect. Current growth pace cited: Close to 12% annualized real GDP - He referenced a very strong month-on-month nowcast reading. One-quarter trend growth cited: 5% to 6% - He said even a lower trend would still be inconsistent with control over nominal spending. Automobile inventory/sales ratio pre/post pandemic: About 2.0 vs. about 0.4 - Used to argue auto restocking can support new-car inflation. Inflation variation concentration: 85% to 95% - He claimed four major CPI categories explain most inflation variation. Major CPI categories cited: Food, transport, housing, and one additional category (implied services/medical-related effects) - He identified the core drivers of CPI. Treasury backtest window: Only about three months of comparable history since 1965 - He argued the exact combination of hiking, inversion, and massive issuance is rare. Hedge fund carry on duration trade: Negative at 5.5% borrowing versus ~4% yield - He said leveraged buyers face poor carry on long-duration Treasuries. S&P 500 earnings trend: Three consecutive quarters of year-over-year declines - Raised as a contrast to the equity rally. Bank credit level: About $12 trillion - He noted bank loans and leases have been roughly flat since early March.

Pivotal Quotes: "What has been particularly unique is that what actually impacts the private sector is something called net interest expense." — Ahan Menon: Explaining why rate hikes have not yet caused a deep recession. "Liquidity is the flow of cash and cash-like assets that potentiate spending in the real and financial economy." — Ahan Menon: Defining his framework for analyzing markets and the economy. "The reason that risk changes over time is because in a certain economic environment, assets of certain types are more or less risky." — Ahan Menon: Explaining why the same Treasury issuance can have different effects across cycles.

Implications: Expect a tougher market regime if QT and Treasury coupon issuance keep tightening liquidity. Tactical preference may shift to cash/short duration now, but if recession hits and inflation cools decisively, long bonds should become the cleaner long trade.