Tax cuts and Bond yields

Yesterday the bill to cut taxes passed in the House. What could passing in the Senate mean for bond yields? Well, we run a budget deficit, which implies that we borrow money as a country-just to finance day to day operations. How do we borrow this money? We issue Treasury notes and bonds backed by the full faith and credit of the United States Treasury. The Treasury has recently decided to start issuing more short-term debt and soften up on issuing bonds around the 10-year mark.

This means that there will be an increasing supply of short-term treasury notes. With increased supply comes lower prices. With lower prices come higher yields on bonds. First, the action of shortening the borrowing duration should flood the market with too much short term debt-increasing bond yields. Second, tax cuts should increase the budget deficit, calling for more treasuries to be issued-more supply. Lastly, the Federal Reserve plans to let $6 billion worth of Treasury securities mature every quarter while also increasing that number by $6 billion per quarter, up to $30 billion.

This means there will be $6 billion less demand for Treasuries this quarter, $12 billion next quarter, $18 billion in the quarter following and so on. This decrease in demand will cause bond prices to fall as less buyers want in. To summarize, The Treasury is issuing more short-term Treasuries (increase in supply-short yields rise), Congress is likely decreasing taxes (increase in supply-short yields rise) and the Fed is letting it’s Treasury securities mature without reinvestment (decrease in demand – yields rise).

If inflation does not surprise to the upside in a consistent manner, this seems like a recipe for higher short rates and long-term rates that are neutral, declining or increasing at a rate slower than short-rates. Either way, a further flattening of the yield curve is in the cards.