It's the bond market
- As much as YOLO-type acronyms and fist-bump emojis are fun, when apprising asset classes, the more helpful points of reference are the prosaic underpinnings of modern financial markets, such as the US bond market and dollar. The world’s reserve currency lies at the heart of global financial system, which is based on debt and leverage. When one is taking a macro view of financial markets, the starting point is always the dollar and in particular two questions; how much does it cost and how many are there relative to demand? When the dollar is outperforming other currencies and US Treasury yields are rising, the answer to these questions is too much and not enough respectively. And because you only live once, it’s worth paying attention.
- The graph below illustrates the trend clearly, with the 10yr Treasury in yellow and the DXY US Dollar Index in blue. The rise in Treasury yields in 2021 is particularly pronounced. From January 1st (vertical red line), the 10yr yield has risen around 70bps to 1.60%. Why is this all happening and what, if anything, will change these trends?
Source: Bloomberg, March 2021. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.
- For the purposes of analysis, the yield curve can be split into roughly two parts. The short end (5yrs and less) tends to reflect central bank interest-rate policy and market-liquidity technicals, especially at the very short end. Further out along the curve (10yr and beyond), the main driver is economic growth (GDP) and inflation expectations. At present, there are things going on both at the short end and the long end, both of which need to be examined.
- Starting at the short end, the US Treasury is running down its reserve balance at the Fed. This balance is called the Treasury General Account (TGA), and during a period of prolific bill issuance during 2020, this rose to a record $1.8t. Secretary of the Treasury Janet Yellen has announced that this balance will be run down to more normal levels through to June, with numbers estimated around $800bn in terms of the size of the reduction.
- The spike and subsequent reduction TGA balance can be seen in the graph below, courtesy of St Louis Federal Reserve data. There are two potential consequences. First, that the Treasury is going to spend a large amount of money without issuing bonds, even as the Fed continues quantitative easing (QE). All else equal, this would be inflationary – the Treasury raised money last year, but didn’t actually spend it.
- From the point of view of the banking system, as the Treasury spends money, so do bank reserves rise – spent money ends up in the bank, and this is where the liquidity problems start. Drawing down the TGA at the Fed means it is not issuing T-bills in the volume it used to. T-Bills are the most pristine form of collateral in the repo market (the cost of sale-and-repurchase agreements or repos depends in part on collateral quality, and short-dated US Treasury bills are top of that list), so when the Treasury issues fewer bills, the repo market tightens up as the stock of good-quality collateral goes down, raising the cost of financing. Fewer dollars, and more expensive – the dollar goes up (see the DXY graph above).
- But the knock-on effect of repo tightness extends out along the yield curve too. The current 10yr on-the-run Treasury note has traded a low as -4% in the repo market, showing that there is tightness further out. This may in part be driven by a desire to short treasuries on rising inflation expectations, but there is another more prominent reason.
- Back in April 2020, the Fed suspended the SLR (supplementary lending ratio). The SLR was introduced in 2010 in the Dodd-Frank legislation to make sure banks were better capitalised. Basically, it meant that, amongst others, the big banks (G-SIBS or globally-significant investment banks like JP Morgan and Citi) had to hold at least 3% more collateral against their lending going forward, and this reserve would have to rise the bigger their balance sheets grew. With the flood of Treasury issuance after the pandemic (to pay for the fiscal response), these rules were suspended, allowing banks to load up their balance sheets to absorb the increased Treasury supply. The exemption ends on the 31st March, and it is unclear whether it will be rolled over. This is a decision for the Fed, but there is clearly political pressure at work here too, notably from Senator Elizabeth Warren (Dem) who has been vocal in calling for the SLR exemption to be ended.
- A return to the old SLR rules would mean banks having to reduce their balance sheets by shedding deposits and owning fewer Treasuries. Not only does this tighten lending, it means less leverage for geared market participants like hedge funds, hence the market sell-off. It also means less demand in Treasury auctions, which, all else equal, leads to higher yields. This is turning into quite a cocktail.
- If that wasn’t enough, not only is Treasury issuance rising (an extra $1tn in 2021 and counting), but inflation expectations are rising, and this puts pressure on the long end of the Treasury curve. The graph below shows 5yr US TIPS inflation Treasury break-evens. Currently this stands at 2.5%, and the period from March through to June is likely to see a dramatic increase in headline inflation due to so-called base effects as current prices are compared to the depressed ones of a year ago (remember when oil was trading in the negative $30s in April 2020?). Add in a rapidly rising oil price due to OPEC not agreeing to increase production and an attack on Saudi Aramco’s refineries, then you get quite a push to short-term inflation pressures, and this in turn pushes nominal bond yields higher.
- The bit equity markets (especially growth-orientated indices like the Nasdaq) really don’t like is real rates rising. In 2021, 10yr US Treasury real rates have risen from -1.09% to -0.64%. All else equal, the perceived discount factor of equity cash flows falls, dragging stock prices lower. Add in tighter financing conditions and banks possibly having to deleverage due to the SLR restrictions, then hedge-fund leverage comes down, further exacerbating the problem. The combination of tighter liquidity, growing Treasury supply and rising inflation expectations is a very difficult trifecta for the market to deal with.
- Who normally rides to the rescue when the market isn’t going up every day? You got it, the Fed. But at a Q&A with the Wall Street Journal on the 4th March when Fed Chairman Jay Powell was asked about all of this (inflation, SLR, liquidity, the stock market), his reply was that they monitored many data points but as it stood, financial conditions were still easy and there would be no imminent action. The markets took fright – the dollar rose, equities sold off, bond yields rose.
- The problem is the Fed is now in a blackout period ahead of the FOMC meeting on the 17th The market is effectively on its own, and it doesn’t like that. The market also now knows that it needs ‘an event’ to force the Fed to intervene. As it stands, a 10% or so fall in the Nasdaq is not enough. Given Powell’s reference to financial conditions, one suspects that a blow out in the credit market might do it. As the graph below of the CDX IG (investment grade) US credit default swap index shows, credit spreads are currently benign even though the equity market is looking increasingly traumatised. The current spread is around 54 versus a March 2020 crisis high of over 140.
- There are a number of things the Fed could do. It could extend the SLR exemption, allowing banks to keep bigger balance sheets. This would ease repo issues and create a bid for Treasuries. They could do a ‘twist’ in QE, selling short-dated Bills to buy longer-dates 10yr and 30yr bonds (easing the repo collateral issue and putting a lid on long-term real rates, weakening the dollar). The game changer would be yield curve control, where rates are capped at a pre-announced level. One senses though the Fed is a reactive not a proactive organisation, so we need a proper market crisis for them to act. Suddenly it’s a very long time until the 17th March when Powell next speaks, and it’s worth noting that more often than not when he does actually speak, the market tanks. Time to stay frosty.