Hawkish Central Banks: Fed QT Threatens Bond Market Liquidity
By the Curmudgeon with Victor Sperandeo
We take another look at the U.S. economy which has yet to confirm a recession. Next, we explain how hawkish Central Banks are driving global interest rates higher. The Federal Reserve doubling the pace of QT, combined with jumbo rate hikes, possess a clear risk to bond market liquidity and will surely result in lower economic growth. Lastly, we examine corporate bond sales, which are still mainly used to fund stock buybacks!
Victor is moving back to his previous apartment this weekend, so his comments this week are short and sweet.
U.S. Recession Watch:
At the Vienna Macroeconomics Workshop in Austria this week, Fed governor Christopher Waller said that continued signs of strong job creation and consumer spending showed that the economy did not fall into recession, even though the Commerce Department reports that the economy contracted in the first half of the year.
Bank of America economists agree. They wrote in a Sunday email to the Curmudgeon:
“Recent employment reports suggest labor demand and employment growth haven’t slowed much in response to Fed tightening thus far. US economist Michael Gapen considers this strong economic data a double-edged sword since it reduces the likelihood of a near-term recession, but also likely brings additional policy rate tightening.
We now push out our outlook for a mild recession to the first half of next year (previously late 2022) and increase our target for the federal funds rate to a range of 4.0-4.25%, with a 75bp hike in September and smaller hikes thereafter.
Given the lag effect tighter policy has on growth and inflation, Global Economist Ethan Harris worries that by focusing on actual inflation to determining when to stop, central banks may go too far (as we’ve been warning for quite some time now). For investors, this means more pressure on interest rates, more weakness in risk assets and further upside for the super-strong dollar.
In our view, these trends only turn when markets price the full fury of central bank hikes and we are not quite there yet.”
Hawkish Central Banks Push Interest Rates to Multi-Year Highs:
Indeed, central bankers’ insistence that they will continue raising interest rates until inflation eases has helped send interest rates across the globe up near their highest levels of the year.
The benchmark 10-year U.S. Treasury note yield, which underpins lending rates around the world, has risen for six consecutive weeks, to around 3.30% on Friday, from 2.57% at the start of August, its longest streak of weekly increases in a year. That puts it close to the peak of nearly 3.50% it hit in June. The 2-year T-note yield closed Friday at 3.563% which was a multi-year high.
Yields on comparable German, French and Italian government debt have also come close to high points for the year, and the rise in government bonds is pushing up borrowing costs for companies as well.
Central bankers have emphasized in recent weeks that inflation remains too high and that they will continue raising interest rates to cool demand, aiming to slow the rapid pace of rising prices in the process.
On Thursday, the European Central Bank raised interest rates three-quarters of a percentage point (75bps), matching the biggest rate rise in its history. The Bank of Canada made a similar increase a day earlier, and a third straight three-quarter-point increase by the Federal Reserve is expected this month.
“Markets around the world are coming slowly to terms with the idea that we are in fact in a paradigm shift,” said Sonal Desai, the chief investment officer at Franklin Templeton Fixed Income, referring to a generational shift in inflation, which is driving bond yields higher. “We are in a new space.”
This week, Jerome H. Powell, the chair of the Federal Reserve, along with other policymakers including the Fed’s vice chair, Lael Brainard, reiterated the central bank’s commitment to bringing down inflation.
“We are in this for as long as it takes to get inflation down,” Ms. Brainard said at an annual conference of the Clearing House and Bank Policy Institute.
Cartoon of the Week:
Cartoon Credit: San Diego Union Tribune
Fed Accelerates Quantitative Tightening (QT):
month, the Fed will double the pace at which it shrinks its balance sheet (Quantitative Tightening
or QT), which grew to almost $9 Trillion.
Starting in September 2022 (this month!), the Fed will let up to $60
billion of U.S. Treasuries and $35 billion of mortgage bonds to roll off its
balance sheet as the debts come due, twice as much as the past three months. Here’s a 1-year graph of the Fed’s balance
Source: U.S. Federal Reserve Board
Bond traders noted the increase in the supply of new U.S. bonds to replace those that have matured and rolled off the Fed’s balance sheet. Those U.S. bonds would now need to be bought by others (not the Fed) which is contributing to higher yields.
Some investors worry that the quickening pace of the Fed’s pullback could become too much for markets to bear, undermining the safety and reliability of the Treasury market.
“Eventually, all those bonds coming off the Fed’s balance sheet are going to disrupt the market,” said Scott Skyrm, a trader at Curvature Securities.
Previous attempts by the Fed to shrink its balance sheet did not go well. In September 2019, the Fed was about a year into the unwinding of the bond-buying program that stemmed from the 2008 financial crisis. Even though it was shrinking its balance sheet at roughly half the pace it is proposing now, a dearth of cash in the system roiled markets. The Fed had to step in and buy Treasuries to help the credit markets function again and restore liquidity.
Other Credit Market Liquidity Risks:
Today, the Fed’s shrinking balance sheet is not the only reason liquidity is deteriorating. The price that buyers or sellers are willing to trade for depends on how sure they are that the price won’t move significantly shortly after the trade is complete.
With so much uncertainty — over the health of the economy, the course of the Russian-Ukrainian war or the path of inflation, to name just a few things — it’s harder to price trades, reducing liquidity.
The sheer scale of U.S. government debt also plays an important role. The Treasury market has doubled over the past decade, to around $25 trillion, as the government’s financing needs have grown. All that debt needs to be bought by someone, and not just the Fed.
If demand for Treasuries can’t keep pace with the supply, it would pull prices down. Prices move in the inverse direction of bond yields, which are a measure of borrowing costs (mortgages and borrowing rates are largely determined by U.S. Treasury rates. Higher Treasury yields would put more pressure on borrowers already grappling with the Fed’s campaign to lower inflation by raising interest rates.
“I am worried that we are piling QT on top of these rate hikes, and it will push us into recession,” said George Catrambone, the head of Americas trading and chief operating officer at DWS group.
Corporate Bond Sales:
Companies have also sought to raise fresh debt this week, adding more bond supply to markets and amplifying the push to higher yields. For example, Apple is gearing up for a four-part bond sale to fund stock buybacks.
Apple is planning to use the proceeds from the sale for general corporate purposes, including buying back shares and paying dividends, the company said in a filing with the Securities and Exchange Commission. The bond maturities range from seven to 40 years.
Bond issuance has long been a key capital-raising strategy for Apple. The company executed a similar offering in July 2021, selling $6.5 billion of notes in four parts, and as of June 25, 2022, it had $94.7 billion in long-term debt outstanding.
To some credit market analysts, Apple’s debt issuance could suggest that bond yields — and interest rates — might still be too low, given that the company still perceives credit as an attractive option.
Victor’s Quick Takes:
Confucius believed that social disorder often stemmed from failure to perceive, understand, and deal with reality. Fundamentally, social disorder can stem from the failure to call things by their proper names, and his solution to this was the rectification of names. He gave an explanation to one of his disciples:
“A superior man, in regard to what he does not know, shows a cautious reserve. If names be not correct, language is not in accordance with the truth of things. If language be not in accordance with the truth of things, affairs cannot be carried on to success. When affairs cannot be carried on to success, proprieties and music do not flourish. When proprieties and music do not flourish, punishments will not be properly awarded. When punishments are not properly awarded, the people do not know how to move hand or foot. Therefore, a superior man considers it necessary that the names he uses may be spoken appropriately, and also that what he speaks may be carried out appropriately. What the superior man requires is just that in his words there may be nothing incorrect.”
— Confucius, Analects, Book XIII, Chapter 3, verses 4-7, translated by James Legge. Confucius (551–479 BCE), a scholar and teacher, lived in a chaotic and violent time in China. He was a brilliant man.
Twenty-one years after the September 11 attacks, we pause to reflect and honor everyone affected by the horrific events on 9/11/2001. We will never forget and hope the U.S. government takes whatever steps are necessary to let that happen again.
Be well, stay healthy, try to find diversions to uplift your spirits. Wishing you peace of mind, and till next time………
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies, and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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