“[The] US yield curve keeps flattening despite risk-on [and] trade relief”, Nordea’s Martin Enlund remarked on Tuesday, shortly after simultaneous statements from the USTR and China’s Ministry of Commerce ignited a rally in the yuan and US equities.
We noted the same thing pretty much immediately. Although the news pushed long-end yields higher, the 2-year cheapened by 7bps and the 2s10s was on the brink of inverting. (It didn’t help that 10-year yields came off the highs as Hong Kong police donned riot gear in an effort to disperse protesters camped out at the airport.)
“Mr. Market definitely doesn’t like Jay ‘behind the curve’ Powell”, Enlund went on to say, adding that we’re 17bp flatter since the embattled Fed chief characterized the July cut a “mid-cycle adjustment”.
This is a problem, as it suggests Powell simply cannot catch up. Nomura’s Charlie McElligott touched on it too, in a short Tuesday morning note.
“Importantly, the 4Q18 into 1H19’s bull-steepening trend is now being powerfully reversed into a rage bull-flattening”, he wrote, adding that “the earlier steepening was representative of the market pricing-in accelerated Fed easing [while] now, the long-end is rallying in manic-fashion because of the market’s capitulation into a hard growth deceleration/recessionary stance”.
The panic grab for duration, Charlie says, is down to the Fed being seen as “behind the curve yet again” and thus unable (or unwilling, and at this point it doesn’t really matter which) to rescue the world from a downturn and disinflation.
He goes on to reiterate Enlund’s point, noting that the perception of Powell and co. being behind-the-curve “has only accelerated since the Fed’s miserly first cut of the cycle in July, especially as they have continued to push the idea of a ‘mid-cycle adjustment'”.
An additional (and perhaps even more vexing) problem, is that the Fed’s (somewhat understandable) reluctance to countenance the idea of a full-on easing cycle is contributing to tighter funding conditions.
“The early resolution of the debt ceiling extension debate means that the Treasury is going to pound markets, as well as dealers who are stuffed to the gills with full inventories, with a flood of new bill supply to replenish cash balances which will further act to extract US Dollar liquidity from the system”, McElligott warns.
BofA’s Mark Cabana has hit this point hard lately. “The debt limit resolution will open the floodgates on near-term US Treasury supply that would likely force the Fed to start expanding its balance sheet by year end”, he wrote in an August 6 note, adding that a deluge of post-debt limit supply will be intermediated “via already bloated dealer balance sheets and into a banking system that is showing increased signs of reserve scarcity”.
Cabana went on to caution that we’re likely to see “material upward pressure on money markets [which] would likely force the Fed to offset these pressures via balance sheet growth or soft QE above the ZLB”.
That last point is notable, to say the least.
Driving the point home, McElligott writes on Tuesday that “this is why overnight funding rates continue to hold above the Fed’s upper bound, while we see FRA-OIS/LIBOR-OIS stresses continue to build and actually further tighten financial conditions, accelerat[ing] curve flattening and inversions”.
That, in turn, could well end up serving as a de facto rate hike unless the Fed does something, where “something” means “takes more aggressive action”, to quote McElligott.
That’s a bit ambiguous, but that’s fine, because while the Fed may be reluctant to act preemptively, the options are easy to enumerate.
As BofA’s Cabana goes to say, the Fed will need to respond to funding pressures (e.g., wider FRA-OIS, wider USD XCCY basis, etc.) first with additional IOER tweaks, which of course are just a Band-Aid to buy time, and then with a possible shortening of WAM, which would help absorb some supply, but would also risk tightening financial conditions. And so, ultimately, Cabana says the Fed may need to take “more powerful steps”, including temporary repos, putting in place the long-rumored standing repo facility or, if that’s not ready to go yet, outright QE.
On that latter option (i.e., the resumption of asset purchases), BofA notes that “the Fed would likely describe [it] as offsetting ‘bank reserve demand and growth in other non-reserve liabilities'”, but no matter how it’s pitched, Cabana reminds you that “it would represent the Fed permanently buying USTs outright to maintain control of funding markets well above the ZLB”.