Interest Rates Rise; Fed Balance Sheet Shrinks, Global Liquidity Flatlines
By the Curmudgeon
Inflation has peaked, the Fed has likely stopped raising rates, but U.S. mortgage and bond rates are rising rapidly. They are either at or approaching multi-year highs (prices are at multi-year lows).
Few have noticed that U.S. mortgage rates closed Friday at a 22 year high:
Product Rate Last week Change
30-year fixed 7.46% 7.39% +0.07
15-year fixed 6.67% 6.65% +0.02
5/1 ARM 6.39% 6.35% +0.04
30-year fixed jumbo7.51% 7.44% +0.07
Meanwhile, the 10-year U.S. Treasury Note closed Friday at 4.16% - a smidgen away from its 4.25% multi-decade high on Oct 24, 2022 (when inflation expectations were substantially higher than today).
One would logically conclude that this should not be happening, but it is! The probable cause is the Feds QT campaign combined with the huge increase in Treasury debt auctions in the next few months.
For many years the Fed was the biggest buyer of U.S. Treasuries and mortgage-backed securities, but now its letting its bond portfolio run off by NOT reinvesting the proceeds of securities that mature.
As of August 9th, the Feds portfolio/balance sheet had shrunk by $0.98T since the portfolios peak of $8.55T in May 2022. Analysis of weekly data suggests the Feds QT is on track to pass $1T before the end of this month. The Fed plans to cut another $1.5tn from its balance sheet by mid-2025.
Heres a chart depicting the steady decline in the Feds balance sheet since late April 2023:
Source: Federal Reserve Board
As a result of QT, the huge demand for U.S. bonds from the Fed has disappeared. Also, Japan (the largest foreign buyer of U.S. Treasuries) is cutting back its purchases.
-->The lower demand for bonds is coming at the same time that the supply is increasing due to increasing U.S. budget deficits.
Earlier this month, the U.S. Treasury Dept announced that it would increase the sizes of its auctions this quarter, and that there would be further increases in the quarters to come. The U.S. posted a $228 billion budget deficit for June, up 156% from a year earlier.
"Financing needs were higher in fiscal year 2023 than what I think many were anticipating," said Meghan Swiber, a rates strategist at Bank of America. She estimates that some auction sizes could reach the peaks hit in 2021, at the height of COVID-19 borrowing. "The longer that the Fed does QT, the more the Treasury ultimately needs to rely on the public to finance its debt, Swiber added.
Because Treasury yields underpin valuations across asset classes, a significant rise would translate into higher costs for corporate borrowers as well as higher U.S. debt service cost which would increase the budget deficit even more. It could also undermine the 2023 rally in mega cap tech stocks, which have very high Price-to-Earnings ratios [1.]. At the start of 2023, the conventional wisdom was that rising interest rates were shrinking the present value of big tech companies future income streams, since higher interest income today reduces the attraction of dollar earnings in the time ahead.
Note 1. Many investment professionals compare the earnings yield (the inverse of the P/E ratio) with the 10-year U.S. Treasury Note yield. As the 10-year rate increases, high P/E stocks become less attractive vs intermediate term U.S. treasuries.
Finally, Cross Border Capital [2.] opines that global liquidity has mysteriously flatlined as per this chart:
Note 2. Founded in 1996 by Michael Howell, Cross Border Capital is a UK based global research group focused on monitoring credit, liquidity conditions and capital flows in over 90 economies.
CEO Michael Howell warns of upcoming trouble: Yields may test 5% before they see 3.5% again!
That would be a major blow to pension funds, banks, and insurance companies which hold huge amounts of U.S. Treasury debt which are hardly risk free.
Be well, success, good luck and till next time
Follow the Curmudgeon on Twitter @ajwdct247
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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