2018 Flashbacks And Upside Down Bond Market Dynamics

With the Fed tapering Treasury purchases to “just” $4.5 billion per day from a peak of $75 billion during the worst of the COVID panic, some believe the stage is set for yields to rise as Steve Mnuchin borrows to fund virus relief measures.

The argument is simple: More supply against a waning bid from Jerome Powell means higher yields.

Occam’s razor aside, simple arguments don’t often stand up to scrutiny, and according to Nordea’s Andreas Steno Larsen, “the Fed needs to buy MORE, if long bond yields are to go up” (all-caps in the original note). 

(Nordea)

This might seem counterintuitive at first, but you have to consider that we live in a world where, to quote Steno Larsen, “substantial Fed QE is the ultimate driver of the credit cycle, which is the only catalyst of the business cycle now-a-days”.

At the same time, it’s worth recalling the events that triggered the mini-emerging market crisis that unfolded in the summer of 2018. In June of that year, then RBI governor Urjit Patel penned an urgent-sounding Op-Ed for the Financial Times that contained the following passage:

Dollar funding of emerging market economies has been in turmoil for months now… The upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts. Given the rapid rise in the size of the US deficit, the Fed must respond by slowing plans to shrink its balance sheet. If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.

The post-financial crisis world has been defined by central bankers mashing the gas and fiscal policy riding the brake. The 2018 experience in the US was a rare instance of the opposite – Trump was mashing the fiscal gas, while Powell was putting the brakes on monetary accommodation. Either way, fiscal and monetary policy have worked at cross purposes for the better part of a decade.

There are clear differences between 2018 and 2020:

• Most obviously, the Fed just finished cutting rates to zero, whereas then, Powell was still raising rates
• In 2018, the Fed was shrinking its balance sheet against an expanding deficit. Now, the Fed’s balance sheet is exploding alongside the deficit, as monetary policy enables fiscal spending
• Rather than turning a blind eye to a worsening dollar liquidity problem (as Powell did at a conference sponsored by the IMF and the SNB two years ago), the Fed is doing everything it can to ensure dollar liquidity is both abundant and cheap, having witnessed an acute episode in March, when the likes of Brazil, Saudi Arabia and India liquidated Treasurys as part of a mad global dash to raise USDs amid the COVID panic

And yet, despite all of that, and even with swap lines having been enhanced and expanded, pockets of stress can (and probably will) continue to show up in emerging markets.

The tapering of Fed purchases could create a squeeze on the margins (i.e., relative to conditions that existed in April and May) due to the same dynamics Urjit Patel discussed in 2018.

Nordea’s Steno Larsen drives that point home in the context of US bond yields.

“When issuance outpaces liquidity additions via QE, it also means that financial conditions are likely to tighten in the EM-space”, he writes, adding that “fewer USDs available for rest-of-world funding in $ will likely work to tighten conditions overall”.

Tighter liquidity (and the risk aversion that goes along with it) may be conducive to lower long-end USD yields (as a haven bid materializes). That, in turn, is bullish for the dollar, which could then be deflationary, in a self-feeding loop.

Throw in the necessity for the Fed of capping yields in order to ensure the deluge of supply associated with the COVID relief spending doesn’t raise the cost of borrowing (and for our purposes here, I’ll just pretend that we have to borrow to finance that spending, a dubious proposition), and you’re left with the distinct impression that long bond yields will stay depressed.

“The consensus take is that a steeper curve and higher longer bond yields follow when issuance is large, and QE is ‘outpaced'”, Nordea says, summarizing.

For the reasons cited above, they “hold the opposite view”.