So Steve Mnuchin is going to sell some debt, ok? And he’s going to be selling a lot of it.
That’s because world-renowned economist Donald Trump has decided that contrary to theory and also contrary to common sense, he’s going to go ahead and pile a deficit-funded tax cut and all manner of other fiscal stimulus atop a late-cycle economy operating at full employment.
The reason he’s doing that is because he needs to fulfill his populist promise to usher in a veritable American renaissance. Despite the fact that no one even knows what Trump means by “great” (more on “the nostalgia of greatness” here), everyone is apparently just fine with mortgaging the country’s future to finance a return to it. Even if it means putting America on a fiscal trajectory with no historical precedent:
That’s on the way to putting America in worse fiscal shape than Italy by 2023 (which, conveniently, is when this will no longer be Donald Trump’s problem).
This is why Wednesday’s Treasury refunding announcement was so closely watched and while you can read the details here, the bottom line is that, as noted above, Steve Mnuchin is going to be selling some debt and while he’s pretty sure it will be absorbed, the question is not whether the market will clear, the question is “at what price?”.
As you’re hopefully aware, this is part and parcel of a wider debate about what happens when fiscal policy turns expansionary in a world where central banks are trying to replenish their ammo by running down their balance sheets or otherwise pulling back on their support for the market. Clearly, central bank asset purchases have distorted the supply/demand dynamics in fixed income beyond recognition and as I never tire of reminding people, that was precisely the point. You engineer a hunt for yield that drives investors down the quality ladder and along the way, everything from the most sterling of credits to the shoddiest of shit gets priced to perfection.
Leaving aside the question of what happens to credit once investors begin to climb back up that quality ladder as risk-free rates rise (hint: idiosyncratic and sector-specific risk will manifest itself in wider spreads), the question for government bonds is simply what the clearing price will be once price sensitive investors (i.e., investors who are not central banks or reserve managers) have to shoulder a greater burden.
That’s the subject of a new note from BofAML which begins with the following chart that shows, to quote the bank’s rates team, “the supply of reserve assets to the private sector tripling between 2017 and 2019 and hitting $1.5tn – this would be the highest level in more than 15 years bar the crisis years of 2008-10.”
For their part, BofAML thinks the market isn’t factoring this in. To wit:
We continue to believe the market underestimates the cumulative supply shock in rates markets. In 2018 alone, we expect to see:
- Fed balance sheet run-off of $229bn in USTs (ca. $362bn including MBS)
- US fiscal stimuli of $200bn
- European Central Bank (ECB) tapering of EUR480bn ($590bn)
- Bank of Japan (BoJ) QQE run-rate reduction of potentially JPY20tn ($188bn)
The implication there is that a rate shock is in the cards and that informs BofAML’s year-end forecast for 3.25% on 10Y Treasury yields, a number which, if you go by the shrieking panic crowd, would mean the Dow crashes to zero on the way to global famine, cannibalism and ultimately, the zombie apocalypse (which is why you need gold and Bitcoin, because there’s nothing like shiny metal and “assets” that rely on an internet connection to protect you when everyone is starving and there’s no infrastructure).
As BofAML goes on to note, “it is very risky to draw any inference from the Federal Reserve’s tapering experience, as 2013/14 marked the beginning of QQE in Japan.”
That’s an argument a lot of folks have made and if you look at the following chart, you can see why they would say that:
One of the issues here is that thanks to where we are in the cycle, the whole “bonds for capital gains” meme may no longer be valid and thus while higher yields should entice a bid, the prospect of buying into an egregious selloff could well discourage folks. Here’s BofAML again:
Demand will often equal supply. The question is not whether we will find buyers for these bonds, but at what price. What is unusual about the current backdrop is that we have the supply of government bonds going up, while rates are rising. We normally observe the opposite – supply going up as central banks are cutting rates – which makes increased supply much easier to absorb since investors can hope for capital gains and are protected by carry and roll-down from steep curves.
There’s more in the full note (which is amusingly entitled “Bonds, bonds, everywhere you look, bonds”), but the bottom line is that in the absence of a foreign, price insensitive bid, it’s left to domestic demand to absorb the supply and that comes at a cost.
“We do expect the transition toward domestic from non-resident investors to result in higher rates, as domestic investors are likely to be more price sensitive than reserve managers,” BofAML concludes.
And that brings us back to Steve Mnuchin and all the new debt he wants to sell you on behalf of #MAGA.
Are you a buyer?
I mean, he doesn’t look nervous, does he?…