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.
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.