Dwindling Yield Supply, Coronavirus, Negative Rate Policies and the Fed

As Chairman Powell finished his two day testimony before Congress, renewed concerns over the integrity of the data around the Coronavirus out of China has been front and center. It’s a terribly unfortunate human situation, which for the markets now brings the Chinese economic story once again front and center. Risk assets remain influenced by lack of yield and supply, equities influenced. Yet in other ways risk assets present as compartmentalizing a likely dramatic slowdown in China.

These markets are not “that” forward looking. There’s a real technical dynamic occurring in global fixed income around lack of quality, positive yielding assets. It very much highlights negative interest rate policies and the global slowdown story of the last two years driven by different factors, yet centered around a challenged Chinese economy with spillover to Asian and European countries. We rolled the year forward and the same dynamics persist and with much different valuations and implications coming out of 2019. A fresh round of liquidity is here.

The largest negative convexity behavior of our lifetime. Buying begets buying the greater the negative yielding asset pool gets.

The dramatic short-term slowdown and shock in China will likely flow through to the Fed in the form of already depressed inflation expectations, challenging the Fed’s stance of needing a “material reassessment” to the outlook to change course. We have written and spoken since early on in 2019 about the Fed’s persistent concern over inflation shortfalls and a persistently low environment of inflation expectations. Since the last tightening in 2018 with an extreme repricing in risk assets, financial conditions have improved but inflation expectations remain unable to recover.

US Corporate Duration (White), Average Yield (Green) and CDS Index (Red) along with the Negative Yielding Asset Pool (Purple)

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This week we had the opportunity to rejoin Maria Bartiromo and Fox Business to discuss the resiliency of markets and Chairman Powell’s semi-annual Congressional testimony.

The implications of the Coronavirus are still very uncertain. The human element is terribly unfortunate. And we hope and pray for containment, transparency and progress.

With an anticipated slowdown in China and global interest rates again on the move lower, the negative global yield dynamics continue to lend support to risk asset as inflows remain strong and global central banks are once again front and center. The Fed included.

In many ways, this year sets up like last: 2019, tariffs and 2020 the virus. China and the global economy ex-US consumer front & center.

And with the US consumer still presenting strong, the Fed is once again in a position to wait and see. Powell reinforced in front of Congress this week.

We have been in the easing camp since early 2019. And our call was for a 50 to 100-basis point reduction without the outbreak of the virus. The current pricing trajectory of the Fed Funds Rate remains lower and we believe the market is reading this correctly.

Forward USD OIS Curve versus 5-Year Forward, 5-year US Inflation Breakevens

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As Chairman Powell finished his two day testimony in front of Congress, thoughts of the Fed’s potential next actions loom despite the Chairman’s insistence it’s “too early to tell”. 

We are not surprised by Powell’s push back on rates this week. This is the Fed’s job. There is no crisis, yet it’s been two years of nagging uncertainty, sluggish growth and with declining inflation expectations. It seems plausible the Fed has more work to do, and not just around the US funding markets and balance sheet.

There were no surprises this week in front of Congress. One by one, and for the most part, the questions for the Chairman were framed along partisan lines and mainly with relation to the economy, jobs and the upcoming election.

We thought Powell did a solid job. Let’s take a look:

CORONAVIRUS

First and foremost, the script is set right now relative to the virus and potential Fed liquidity: more time needed. We think it’s a fair assessment. Senator Tom Cotton from Arkansas issued Powell a stern warning about the integrity of data coming out of China. The news flow over the past few days puts him in a good light.

In the end (our view), the narrative is the same as last year: all relative to the impact on the US economy and consumer. Powell was clear this week: he expected the impact to be felt “soon” and the Fed will assess.

For sure, Powell and many other voting Fed members are sticking to the need for a “material” impact to the outlook for a change in stance. There is nothing inappropriate with this posture from the Fed.

Kaplan

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Powell (Testimony)

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Harker

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Kashkari

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To us, this lends itself to more of what we had last year with the market leading the Fed should the data start to trickle weaker. In other words, like last year if the data in the US stalls, look for the market to test the Fed’s meaning of a need for a “material reassessment” to the outlook and specifically around the timing of what’s priced into the forward curve: a gradual decline.

US FUNDING

The funding markets have calmed. We’ve spoken, and Powell has been clear, about how daily Fed operations conflicts with the Fed’s ample reserve framework. The Fed has been very open and vocal about this. Powell front and center.

Yesterday, the New York Fed released its new schedule for Repo operations and T-bill purchases. As expected the Fed continues to scale back on TOMO while keeping the T-Bill purchases at $60 billion per month.

In general, and when looking at the Fed’s balance sheet, bank reserves are in far better shape than in September. The new schedule is very much in line with Powell’s communication to the market over the past few months of reducing Repo operations while maintaining its goal of adding to permanent reserves with asset purchases (NQE).

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With the Effective Fed Funds rate trading through the IOER, the cleared rate for the Repo operations is still presenting opportunities for cheap funding relative to market rates.

In other words, it’s difficult to judge the meaning of “oversubscribed” in a scenario where a true cost for money is not present. Raising minimal bid levels would be a true test for the market at this point, yet unlikely to happen through the transition period. The Fed is aware.

Effective Fed Funds, General Collateral and the Interest Rate on Excess Reserves

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Nonetheless, the Fed has finally come around to looking more closely at its regulatory framework. Powell was questioned directly on it this week and answered very clearly:

Honing specifically at bank stress testing, the Chairman was clear about bank preference for the use of reserves (cash) over Treasuries relative to current regulation.

Code Of Federal Regulations

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How the Fed evens the playing field between reserves and collateral for the stress testing is a work in progress, although small tweaks in the language would seem to get the job done and with little risk to the safety of the banking industry. Credit risk no issue with Treasuries, yet market volatility is relative to cash reserves.

At a minimal, the fact it’s being actively discussed and likely addressed in the coming months in constructive. With bank reserves now over $1.6 Trillion, we are comfortably above the $1.5 Trillion floor the Chairman has now consistently referred to. 

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POLICY REVIEW

As the Fed continues to conduct its policy review, questions came in about the tools the Fed has in fighting the next downturn. The answer was clear from Powell: 

1) Rates

2) Forward Guidance

3) LSAP (Yes, QE)

Make no bones about it, the Chairman said the Fed would “pursue all and very aggressively” 

The Fed is keenly aware of the lower bound. There explicit and frequent discussion of late is telling: decent likelihood we could head there.

In a world now of Trillions in negative rates, the Fed is being explicit of a) tools they have now and b) used before to avoid such a scenario. The policy review underway is very much in the spirit of exploring all “potential tools” within the Fed’s statutory framework as to best carry out policy measures should a deep decline in the economy occur.

One must credit Powell and the Fed for having the common sense to do this while things are still seemingly in good shape. When all is said and done, this is a Fed that doesn’t want to use bullets on rate. It was very obvious last year with the “mid-cycle adjustment” and we suspect will be equally so this year should the slowdown abroad from the virus prove costly for the US economy. 

In the end, the efficacy of the Fed’s toolbox 10 years after the global financial crisis is very much in question.

SOFR

The show goes on. Lots and lots of questions on SOFR. The Chairman was very clear, no guarantees Libor will exist past 2021 and the movement toward SOFR is alive and will move forward. Although Powell acknowledged the Fed is working with certain segments of the banking industry for a “credit” sensitive alternative to SOFR, too much time and public relations has been invested by the Fed to shy away from SOFR at this point. And certainly this was the tone from Powell yesterday. 

Our thoughts from December, 2019:

https://www.linkedin.com/pulse/path-sofr-alternatives-gregory-s-faranello-cfa/

LABOR SLACK

Powell was questioned multiple times on the job market. Phillip’s curve, inflation, wages and productivity. In the end, the reality is despite an extremely low unemployment rate and 10 years into a recovery, wages have risen by only a small amount and inflation readings are still muted.

There is no one answer: technology, social media, demographics you name it. The Fed has been very vocal about the new norm of lower global neutral rates and natural rate of unemployment. In plain English it means a Funds rate of X, may simply not be as stimulative as one thinks. 

THE DEBT

Powell was clear here: it’s a growing problem. No secret. We are simply not growing the economy fast enough, coupled with the entitlement side of the equation a continued issue. 

Specifically, Powell referred to the cost of delivering healthcare in the US relative to our global peers. It’s simply too high as a percentage of GDP. 

This is not a new theme within central bank testimony. Yet the numbers now are staggering and our Deficit to GDP ratio has been moving in the wrong direction now for years. Growth rates have come down, and the uncertainty we’ve been experiencing with the globally is very real in the US equation to deficit, budgets and debt.

When questioned on the President’s budget, Powell was clear: the discretionary components get all the press coverage and the mandatory spending (social security, medicare and medicaid) is where the problem lies. There is no reason why the US economy should not grow at close to 3%, yet with all the uncertainty still persisting around the globe is seems likely to come in closer to 2% for all of 2020 at best.

In general, we are moving closer to MMT. There is no fiscal responsibility in D.C.. It transcends party for years. We are running structural deficits, and the Fed is likely to continue to absorb the backlash regardless of political party.

Keep in mind, this is occurring with positive GDP

Chart #1:

Fed’s Balance Sheet, Total Outstanding Treasury Supply and 30-Year US Treasury Yields

Chart #2:

Federal Deficit as a percentage of GDP

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THE CURRENT MARKETS

Risk assets continue to hold up. It’s less about the crystal ball and more to do with central bank liquidity again and yield dynamics globally across asset classes. We are not endorsing it, but this is where things are at.

Global fixed income has been crowded out by negative interest rate policies. Which now, 10 years after the global financial crisis are well embedded. One can no longer look toward the future with the past as a playbook. This is a very different market in 2020 relative to rates & risk asset valuations at today’s levels.

Bad decisions get made in environments like this. Yet, it’s not conceivable to determine an end point to that. Many decisions get forced because of pure mathematics and needs. And in the charts we laid out, bigger picture dynamics are clear.

For now, it pays to have an eye on the big picture themes, while also recognizing the central bank community is not backing away tomorrow, next month or this year.

10-Year US Treasury Yields

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In looking at 10-year US yields going back to 2012, we are still within the broader range. Short term, a 1.50-1.70% range holds tight within the broader range established coming out of the summer of 2019 (1.50-2%).

In the end, a break and close in US 10-year either side of this short term range will indicate a shift in tone.

We will be traveling next week and will be back to publish again on February 28th. Thank you for all of the support.