Treasury Hints of Smaller Auctions If Deficit Shrinks

Marwood Jenkins |Photographer's Choice | Getty Images

The Treasury Department said Wednesday it could trim the size of its auctions in coming months, depending on the budget gap, and expects to issue a floating rate note, its first new product in 15 years.

The Treasury also said it was leaving the size of its auctions unchanged in the current quarter. It announced the three-year, 10-year and 30-year auctions will remain $72 billion.

The announcement was expected by many in the market but there was an added buzz around the refunding plan. Talk had picked up that the Treasury might be getting ready to pare down auction sizes, after it cut back on T-bill issuance this past week.

The bond market immediately began to speculate that the Treasury sees a smaller deficit, higher taxes and therefore less need to issue a much longer duration debt. The speculation was one of the factors that helped drive yields lower.

(Read More: You Should Watch Next Week's Treasury Announcement)

The Treasury also elaborated on its plans for a floating rate note, saying it would issue a final rule on the new notes and expects to hold the first auction in the last quarter of this year or first quarter of next year.

Floating-rate debt pays interest based on how interest rates move, unlike fixed rate securities. The floating rate notes would need to have a benchmark to be measured against. The Treasury said it would use the weekly high rate of the 13-week Treasury bill auctions as the index.

The Treasury also said that as usual after the April tax season, its borrowing needs declined. It addressed it by reducing weekly bill issuance, and that will remain the case through the third fiscal quarter.

(Read More: US May Reduce Bond Auctions as Budget Gap Shrinks )

"Depending on how the fiscal situation develops,Treasury may decide to gradually decrease coupon auction sizes. Treasury will continue to provide guidance to market participants regarding any change in the fiscal outlook that might impact the government's financing needs," it said.

Pierpont Securities economist Stephen Stanley said the market may be anticipating too much from the Treasury announcement.

He said the Treasury is using the downsized bill auctions as a "shock absorber" to accommodate temporary factors affecting funding needs. "If a determination is made that the budget outlook has improved on a sustained basis, then it will be time to discuss tweaking coupon sizes," he wrote in a note.

He also noted: "I fear that the wrong impression has been left. The reality is that the default position is steady coupon auctions, and it would take a positive surprise in the budget outlook (i.e. beyond just the current quarter) to change that. I believe that market participants will walk away from this announcement assuming that there is a significantly better than 50-50 shot that coupon sizes will be cut within the next several months."

The Treasury also commented on the debt ceiling, but did not forecast how long the U.S. can avoid hitting it when the limit takes effect later this month.

"Extraordinary measures will provide sufficient "headroom" under the debt limit to allow the government to continue to meet its obligations for a period of time after May 19," Treasury noted. But it said there are a number of factors that make it difficult to provide a forecast on how long the extraordinary measures will last—including the effect of the new higher tax rates on households earning more than $450,000, the economy and the impact of sequestration.

"We will provide greater clarity at a later date regarding how long extraordinary measures will allow Treasury to continue to borrow," it said.

The 10-year yield dipped to an intraday low of 1.62 percent Wednesday, because of weak data on the jobs and manufacturing front, in particular. The ADP payroll number of 119,000 was well below expectations and signaled weakness ahead for the April unemployment report being released Friday.

(Read More: More Money-Printing? Here's How It Could Happen)