Here’s why the U.S. Treasury may struggle to take full advantage of Fed’s bill-buying program

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With the Federal Reserve set to hoover up billions of dollars of short-dated bills every month, some have called for the Treasury Department to meet the central bank’s demand.

But market participants say the Treasury was unlikely to make radical adjustments to what maturities will carry the brunt of the government’s debt issuance because the U.S has historically avoided making sharp changes to its debt financing strategy. Still, many expect the Treasury to gradually increase its bill sales if only to resolve future budget shortfalls set to widen from next year.

“The Fed’s purchases create a lot of extra demand and should increase the market’s overall capacity for bills. Treasury would be smart to take advantage of the situation while they can,” wrote Ward McCarthy, chief financial economist for Jefferies.

In early October, the Fed announced it would buy $60 billion of bills every month at least through the second half of 2020, as part of its strategy to expand the balance sheet and soothe funding problems in money markets.

This comes as the federal government is expected to rack up trillion-dollar fiscal deficits beginning from 2019. The U.S. Treasury said Monday it expected to borrow $352 billion in the fourth quarter, which is $29 billion lower than previously estimated.

Investors say the Treasury Department is reluctant to ramp up issuance of certain bond tenors in an opportunistic fashion, as it wants to avoid causing sharp changes in the average maturity, or the duration, of the outstanding government debt.

“A pillar of Treasury’s debt-management policy has been to operate in a ‘regular and predictable’ manner. Thus, changing its auction calendar on short notice and without consulting its primary dealers or the TBAC would be out of character with Treasury’s deliberate approach to debt management,” wrote analysts at JP Morgan, referring to senior executives

They added that the widening deficits also means the Treasury will not want to shrink the size of its auctions for longer-term bonds in favor of bill sales.

JP Morgan projected that the government’s borrowing needs were $500 billion greater than the amount of financing the current configuration of debt auctions could deliver in every year between 2021 and 2025.

Another concern is that if the Fed raises rates in the future, the central bank may end up financing its debt at higher rates, said Steven Zeng, a Deutsche Bank strategist.

Senior executives at Wall Street firms who are part of the Treasury Borrowing Advisory Committee (TBAC), which helps consult the government on how to borrow funds from the market, have recommended for bill issuance to avoid surpassing around 25% to 33% of outstanding annual sales.

Zeng forecasted the U.S. Treasury to sell less than $200 billion of bills in 2019 and 2020 each, between 14% to 17% of annual issuance. Once accounting for the Fed’s debt-buying, net issuance could even turn negative next year, starving private investors who may want to purchase bills.

Market participants have also complained the Fed may have to source beyond Treasury bills if it wants to increase the balance sheet at the central bank’s desired pace. It’s why some say that the Fed should widen its debt-buying program to coupon-bearing bonds that carry maturities of more than a year.

Mark Cabana, head of short-term rates strategy at Bank of America Merrill Lynch, said the lack of bills circulating in the secondary market meant primary dealers were buying bills at Treasury auctions and directly handing it back to the U.S. central bank often on the same day, instead of the Fed

See: He warned the Fed might lose control over a $2 trillion interest-rate market — Now he says it might happen gain