Over The Line! Who Will ‘Tolerate’ Higher Long-End Yields?

Over the weekend, in “SpongeBob SquareBanks“, I talked at some length about duration absorption by central banks in the back half of the year.

I realize that’s something of a dry subject (and there’s a sponge joke in there somewhere), but it’s crucial. Governments’ borrowing needs are rising in light of stimulus and other virus relief measures, and to the extent that’s funded at the long-end, it ostensibly has the potential to push up yields and steepen the curve.

There are estimates for the major developed economies in the linked post, but focusing on the US, Steve Mnuchin appears poised to outrun Jerome Powell in the second half, especially with another COVID relief package likely to make it through Congress, even if it ends up being much smaller than the $3 trillion+ in additional spending Democrats would like to see.

Net coupon issuance was obviously deeply negative in March and April as the Fed front-loaded buying in a bid to smooth market functioning. The (im)balance will flip going forward, as more stimulus comes down from the Hill and the funding mix changes.

“While Phase 4 stimulus is still being negotiated and there is considerable uncertainty surrounding its size and scope, we expect it will add roughly another $900 billion to the deficit with $600 billion of financing needed in calendar year 2020”, Deutsche Bank writes, in a note dated Friday. The following passage is key, as it speaks to the shift in the funding mix:

We expect the Treasury to announce another round of coupon size increases in August. They will likely be smaller compared to May, and there is scope for coupon sizes to stabilize after November. For H2 2020, we are forecasting $1,043 billion in privately-held net coupon issuance (vs $567 billion in H1) and $350 billion in net bill issuance (vs $2,663 billion in H1), for a full-year total net issuance of $4.6 trillion.

As discussed in the linked post above, the mix and the appetite from private investors are critical determinants of what the future holds for yields and the curve.

“The trajectory of the level of yields and the term premium depends critically on the maturity distribution of future issuance and the presence of sources of demand other than the Fed”, Deutsche Stuart Sparks says, adding that equity outperformance should boost duration demand from pensions, while yield pick-up considerations will mean reasonably robust appetite from foreign investors in NIRP locales, especially as hedging costs come down.

But, again, Mnuchin will be issuing faster than Powell is buying, so to the extent any demand “shortfall” isn’t made up elsewhere, the Fed will have a decision to make.

“The open question remains whether the Fed – or markets – will tolerate materially higher long-end yields”, Sparks goes on to say, before noting that “the June experience suggests that the answer is ‘no'”.

“Positive 30-year real yields turned the equity market lower and the USD higher on a broad basis”, he writes, adding that he “concurs” with the market reaction and thereby “expects the Fed’s policy apparatus to continue to depress yield levels and the term premium” over the near- to medium-term.

Looking ahead, Deutsche sees the Fed’s balance sheet rising to some 40% of US GDP by year-end. That would be more than double where it sat at the end of last year.

Accounting for the run rate of UST and MBS purchases announced at the June meeting and assuming $500 billion in estimated purchases for the PPP facility and $350 billion estimated loans and assets purchases across the corporate credit, municipal bond, and Main Street lending facilities, the bank says we could get to $8.5 trillion by December.

And that’s assuming nothing goes “wrong” that prompts Powell to ramp up purchases beyond the baseline levels set three weeks ago.