Don’t Fight The Fed

John Leiper – Head of Portfolio Management – 26th May 2020

Over the last decade, the Fed has increasingly resorted to unconventional monetary policy, such as quantitative easing, or QE, to stimulate the economy.

In short, QE is where the Fed buys bonds to inject newly created money into the system to stimulate the economy.

This has happened 4 times previously, as represented by the grey bars in the chart below. We are currently in the fifth iteration of QE.

During these periods, and despite the Fed actively purchasing government bonds, prices have fallen. This is shown by the blue line, which represents the year-on-year change in the 10-year US Treasury yield. When yields rise, prices fall.

At first that might sound counterintuitive. However, it makes sense when you consider the main aim of QE is to stabilise the economy, increase growth and reflate inflation expectations, all of which are negative for bonds. Specifically, QE increases the supply of US dollars, thereby increasing liquidity, risk sentiment and risk assets, resulting in higher government bond yields. This mechanism is covered in more detail here and here.

As shown in the chart, there is a clear correlation between the movement in the 10-year US Treasury yield, in blue, and the pink line.

The pink line represents the difference between Fed purchases of government bonds (QE) and US Treasury issuance (of government bonds). When the pink line goes up, the Fed is increasing purchases relative to US Treasury issuance and bond yields rise. When the pink line goes down the Fed is reducing bond purchases relative to US Treasury issuance and bond yields fall.

On mobile: review chart in landscape mode

At least that was the narrative for QE 1-4….

The big difference this time around is the coronavirus and the sudden and dramatic devastation it has inflicted on the economy. Government rescue programs will necessitate trillions of dollars’ worth of funding. To pay for this the US Treasury is ramping-up bond issuance. In early May the Treasury announced it would need to borrow $3 trillion by the end of June which is three times the amount it borrowed for the full 2019 fiscal year. That is a huge sum of money and the final full-year figure will likely be much higher.  

The current market consensus is that the huge stimulus measures announced by the US government and the surge in liquidity unleashed by the Fed is sufficient to solve the problems facing the US. This is reflected in the strong recovery in US equity prices, up over 30% since the March bottom. However, in a scenario where the recovery is not V-shaped, and the economic damage caused by the coronavirus proves long-lasting, resulting in widespread corporate insolvency, then this could prove wishful thinking.

Contributing to the problem is the fact this perception of a surge in liquidity, which is bullish risk assets, could prove to be a mirage. This is because the sheer scale of pending US Treasury issuance could overwhelm Fed bond purchases going forward. Anecdotally, Fed bond purchases have already fallen from $75 billion per day, at the height of the crisis, to $6 billion per day this week even as US Treasury issuance ramps-up. If the Treasury issues more bonds than the Fed buys, this could drain liquidity, and US dollars, from the system, hurting risk sentiment and resulting in a fall in the dotted pink line, alongside US Treasury yields (and global equity markets).

 

A different perspective is that the resulting surplus of bonds could see bond yields rise…

A different perspective is that the resulting surplus of bonds could see bond yields rise, as the absence of the Fed (as buyer of last resort) reduces market confidence, and purchases in the private sector, and the sheer scale of debt brings the credibility of the US government into question. However, the Fed could not countenance such an outcome as it is important investors retain faith in the US financial system and its ability to repay debt. Further, the US remains the ‘cleanest dirty shirt’ in the laundry basket and the positive yield on offer, given low FX hedging costs, continues to attract demand for US debt which is backed by the “full faith and credit of the US government”. This is evident from last week’s 20-year bond auction, the first since 1986, which attracted bids in excess of $50 billion versus $20 billion available.    

The alternative scenario is one in which the dotted pink line continues to rise and the Fed increases purchases relative to the significant increase in US Treasury issuance. This is likely because the Fed has thrown away the rule book and shown it is willing to do whatever it takes to support the economy. This now includes back-stopping almost every investment vehicle going including investment grade debt, high yield bonds and “Main Street” via loans to businesses. The only thing the Fed is not buying, yet, is equity and even that remains an outside possibility (they already do it in Japan). There is now almost no distinction between the Fed and the Treasury. The credibility of the central bank (already questionable) is now under threat and there will be long-term consequences to these developments, namely inflation, which is bearish government bonds.

Multiple factors affect the US Treasury bond market, not least of which is the ongoing development of the coronavirus, the hunt for a vaccine and the economic recovery to come and whether that recovery is V, U or L shaped. Another big question mark concerns the clear inflationary consequences of both the coronavirus and the policy response to it, and the extent and timeline over which these forces emerge, against broader and more structural disinflationary headwinds. This will be the subject of a future blog.

For now, we are broadly neutral US government bonds. However, over the medium term we think the dotted pink line will rise and as such we are positioned for higher long-dated US Treasury yields. We are already seeing this play out via a steepening of the yield curve as shown in the second chart below. As always, we continue to monitor the situation, our assumptions and portfolio positioning.  

On mobile: review chart in landscape mode

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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