Fed communication is clear, Deutsche Bank’s Stuart Sparks writes, in a new note.
Negative short rates have been rejected as a short-term policy tool for additional easing when it comes to combatting the crisis.
“The implication is that additional easing will be provided through balance sheet growth”, Sparks goes on to say, reiterating the message from a note out Thursday, and driving home a series of points made previously and documented extensively here in “How Many Trillions Equals Negative 1?”
The parade of Fed officials the market heard from this week were unanimous in rejecting negative rates. If that’s too strong, we can say they were unequivocal in indicating that the entire tool kit would be exhausted before considering cutting rates below zero. Jerome Powell attempted to dispel the idea on Wednesday, although as Nomura quipped, his remarks had a kind of Lloyd Christmas feel to them.
If negative rates aren’t in the cards, and the Fed intends to engineer policy that’s actually stimulative, the balance sheet will have to keep growing. That’s the thrust of Sparks’s message, which is the same as it was in weeks previous: r* is somewhere around -1%, and absent negative rates, getting there will entail QE of $3.3 trillion, enough to soak up Treasury coupon supply for the rest of the year – and then some. Here is the key passage from Friday’s note, which echoes previous research:
Fed research suggests that $100 billion in QE has approximately the same impact on year 1 growth as 3 bp of policy easing. To ease to the same degree as 100 bp of short rate cuts, the implication is that QE purchases could be as much as $3.3 trillion. Purchases near that magnitude would create a material supply/demand imbalance that should significantly depress the term premium from current levels. Given our projections for Treasury coupon issuance and Fed QE purchases, we estimate that Fed demand alone will outstrip Treasury supply by approximately $900 billion over the remainder of the year.
Note that yield-curve control purchases are baked into the forecast starting over the summer, as is a projection for “steady state” (if you will) monthly QE.
The Fed on Friday said it will slow Treasury buying again, this time to $6 billion per day next week, from $7 billion. That run rate is still very high by any standard outside of the current context, although well off the unfathomable pace seen during the height of the panic.
Take this into consideration when you ponder shrill warnings about the debt America has chosen to issue (and note that issuing debt to pay for virus relief is a choice, not an imperative) in conjunction with recent economic rescue packages.
Earlier this month, the refunding announcement was met with a predictable cacophony of warnings about the purported perils of the coming Treasury supply tsunami. I scoffed at those warnings. When it comes to coupons, the Fed is going to absorb all of it – plus hundreds of billions more. As for bills, they’ll step in with purchases and cap rates if they have to, although it probably won’t be necessary. For more on that, see “Zoltan Pozsar On Money Market ‘Singularity’ And War Finance“.
Additionally, Deutsche’s Sparks doubts whether falling Treasury yields are going to mean subdued demand from other investors.
“We do not subscribe to the argument that end-user demand for Treasuries is negligible at these yield levels”, he writes, in the same Friday piece, before noting that the hedged yield pickup on the long bond compared to JGBs and Bunds makes USTs attractive compared to domestic alternatives for investors in Europe and Japan.
(Deutsche Bank)
Finally, Sparks says he also sees pension investors as “another significant source of demand for duration even at low general yield levels”.
The narrow takeaway from all of this is a bullish backdrop for bonds, and flattening pressure on the curve.
But from a macro perspective, I would emphasize two things.
First, we are now in an era of administered prices, something Sparks himself has repeatedly emphasized in precisely those terms. The Fed is going to absorb coupon supply tied to the virus relief packages. As Zoltan Pozsar made clear on Thursday, there are four pools of liquidity that will soak up bill supply, and failing that, the Fed will step in and simply cap yields.
“It’s war finance, and the Fed appears committed to ensure that collateral supply (US Treasury issuance) does not outpace the supply of reserves by a crushing margin”, Pozsar wrote. “Ongoing QE ensures that; standing liquidity facilities ensure that; and changes to the edifice of Basel III ensure that”, he went on to say, adding that “the Fed is laser focused on ensuring there is enough balance sheet and reserves to meet the US government’s and everyone else’s growing credit needs”.
Second, and obviously related, yields are thus a policy choice. The US is under no obligation to pay “market prices” on any debt it chooses to issue. We’re not all the way down the road to 100% administered markets, but we’re getting there. The crisis has accelerated our journey.
Read more: ‘There’s No Such Thing As A Free Market.’ Imagine A Future Where Asset Prices Are Administered
QE is really the only option and it is of limited utility in this environment. Negative rates are not some magic elixir that will spur growth — look no further than Japan — and does anyone advocating NIRP really believe that we could go infinitely negative? Accepting the reality that rates do have a lower bound (and does it really matter whether that is 0 or 50 basis points negative except to banks, savers, pension fund managers, entitlement actuaries?).
It seems as though many people do not realize that the Fed is neither omniscient nor omnipotent. The Fed cannot fix this (and people should stop expecting it to –they have amazingly kept the financial world from imploding) alone even if its balance sheet grows to 10T (as I believe it will –at a minimum). A very robust fiscal stimulus (infrastructure along with the House Bill might be a start) is the only path forward –and very long and arduous that path will be. Our political, not financial, institutions must see us through this crisis as bleak as that prospect is –but we did start the Great Depression with Hoover –let’s just hope we opt for an FDR rather than a Hitler. . .
Our institutions , political as well as economic were not designed to function in a world of metaphysical reality… This post is exploring the edges of just such a world….Reading Dalio ,other than today,s post , generally gives one a reassurance that we live in a world with limits unlike the concepts of infinity which seem to have become available rhetoric to describe Financial events nowadays.
Unless the guardrails fail us totally we are likely approaching another event in history where the Deck gets reshuffled and the same game is dealt only the players having to some part changed roles…
The world has changed but I doubt the species , referring to modern man , has been able to shed it’s stripes to keep pace…Surely the toughest task is to keep something like this forum fact based but thanks for the effort H…….
It seems to me that this market administration is like pushing on a bag of goo. Somewhere else something will push out. I am wondering what the side effects of administered primary markets as it relates to investment alternatives.
I have not read any where what is known (or theorized) about actual side effect of administering the markets. Maybe could this be the subject of a future post?
I since read link and link to link. However I only saw an honorable mention go to FX markets. Clearly the Fed has not targeted FX markets directly. I did see some discussion how this lets the ‘real’ or main street economy float with volatility. This side effect should affect the ability of the FED to administer the markets, at least on the margins.
I also wonder if this administered market envisions at least part of what happened in Japan.
In addition to J-Pow standing on the back-end of the UST curve, I am also seeing research notes indicating that speculative short positions in 30-Year UST Futures are back at all-time record levels. So any jolt of risk-off in the equity markets may lead to a rush for long-dated UST’s, and potentially a violent unwind in those short 30-Year futures positions. Wouldn’t be surprising at all to see 30-Year yields back below 1.00% at some point this summer.
The singularity concept is compelling (thanks for sharing that H-man). And as the FED’s balance sheet is theoretically unbound, it could go to infinity before letting rates rise amidst a depression. But so much for anti-NIRPian forward guidance if (“when” in my view) deflation knocks on the front door, and real rates start rising. I guess that would mean the rest of the “toolkit” has been exhausted, because they’d have to go negative regardless of what they may say now.