Real Rates and Market Confidence
Updated: Apr 2, 2020
Central banks are going to have to intervene in a much larger way.
Summary:
The large debt increase programs post GFC and post 2018 give a clear indication of how the US Treasury will issue increased debt going forward.
The new $1trn commitment comes on top of a requirement to already issue $1trn of new debt for Trump's pre-Covid19 existing deficit.
There are 3 sources of demand. Foreigners and private sector domestic investors are unlikely to meet the demand, leaving the Fed to do the heavy lifting of purchases.
Sunday's announcement by the Fed to purchase $500bn is only the start given the absolute numbers - expect far more in the days/weeks ahead.
The 160bp round trip rise in real rates might have found a temporary respite. Further Fed purchase announcements could lower those rates, suppressing risk asset volatility (as private sector assets will not be diverted to fund the deficit).
As the above chart shows, the same dynamics are at play in other major economies.
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Covid19 Fiscal response - new debt supply.
As to be expected, governments have responded to the potential economic fallout from Covid19 with large fiscal packages. Some measures are direct through paying compensation to laid off workers and assisting companies with their cashflow, others less so by offering guarantees to banks to lend to corporates. The numbers are huge (e.g. US $ 1trn, UK £ 350bn) and there are details on how it will be spent, but what has not been fully discussed is the how it will be fully financed, how it will impact existing high debt levels and what the debt servicing requirements will be in the future.
As discussed in my last blog, the governments of the largest DM economies (US, EUR, Japan, UK) are facing the Covid19 outbreak with the weakest post war sovereign finances, with debt to GDP levels not having recovered from the Great Financial Crisis (GFC).
The good news, though, is that the markets have plenty of examples of large scale debt issuance in the post GFC environment and how demand for that increase was satisfied. For the purposes of understanding how this might pan out, I set out below the examples of the post GFC $6.5trn increase in US Treasury debt between 2007 and 2012, and the more recent $2.7trn increases since 2017 to finance Donald Trump's fiscal giveaways.
Figures 1 and 2 : Previous examples of increases to outstanding US Treasury Debt
How and what was issued? The charts below shows the monthly issuance of each instrument available to the US Treasury (UST) to raise finance in the markets (the data is 12mth moving average to smooth the charts). It shows that in both instances of large debt increases, the same strategy had to be followed : An initial very large increase of Bill auctions (note scale of right hand axis), then immediately followed by increases to short end bond auctions (3 and 5yrs), and then notes (10s) and to a lesser extend bonds (30s). Note that the sums were so large post GFC that the UST had to introduce new maturities of 3s and 7s and then FRNs, and more recently they have introduced 20s.
Figures 3 & 4 : Monthly debt issuance (shown as a 12mth moving average)
So given that there is a good guide on how the UST will raise a mountain of debt, it's worth taking a look at the absolute number in the context of the existing debt financing program. It is worth remembering that extra new debt coming to the market would be in addition to the ~ $1trn of debt already expected to be issued to finance the 2020 Trump deficit. Table below shows the annual Gross and Net supply for US Bills and Coupon Bonds for the last 19 years. key points are:
1) Gross supply of Bills has risen from $1.7trn annually to $9trn annually (note there is a lot of double counting as most Bill maturities are <1yr). Net Bill issuance fluctuates with immediacy of needing funds - check 2008 and 2018.
2) Gross supply of Coupon Bonds has risen 9.3 times in scale since 2000 and 4 times since 2007 (pre GFC). Like Bills, net supply of Coupons fluctuates - it rises after net Bill issuance.
3) Total gross issuance is high due to the huge redemption profile (4 times the amount of coupons compared to the amounts in 2000). The UST has to be very careful with its issuance program - any problems would lead to a loss of confidence with huge implications for the financial markets.
4) Total Net Supply was already at levels consistent with the GFC debt issuance levels - that is the scale of Trump's deficit largess.
The UST is now walking a refinancing risk tightrope - it has to get things right.
Covid19 Central Bank response - new debt demand
Whilst there is clarity on the debt supply and how it will fit on existing issuance, there is far less transparency on who will buy it. Sources of demand can be broken down into three categories : the FED (QE programs), Foreigners (mainly Central Bank reserves) and Domestic Investors. Looking at the two episodes of debt expansion above, its' clear to see the important role that the Fed and Foreigners had in absorbing a large part of the debt supply.
Right chart shows in the heavy supply years of 2008 - 2012, domestics never had to absorb >50% of the yearly issued debt. But 2018 was a different story, as the Fed was a net seller of debt on the open market and foreigners outstanding holdings were unchanged, requiring domestics to buy all the debt.
Going into the large issuance program for 2020 and beyond, one has to question the appetite that China and EM countries will have for UST debt (there was an EM currency shock in 2018, as there is today). That would suggest the burden of demand remains on the FED and domestic participants (mutual funds, insurance and pension companies and householders).
Given the current large scale deleveraging, and tremendous volatility that means holding long dated assets is extremely difficult, it seems hard to conceive real yields remaining where they are should the Fed buy only a relatively small of Bills and Coupons. Providing repo facilities is an important liquidity issue, but does not sort the financing of the US Government.
The chart of the 10year UST Real Yield shows how real yields rose dramatically in 2008 on the back of impending supply, in 2013 when the Fed threatened to taper more than the market expected and in 2018 when debt issuance rose and the fed was tapering its purchases. If domestics have to buy, then private sector investment dollars will end up being diverted towards funding the US deficit, which like 4Q2018 will not be a great outcome for equity and corporate bonds.
For this reason it is unsurprising that the FED has ramped up its purchases, promising last Sunday to buy $500bn of Bills and Coupons (and $200bn of MBS). Given the debt numbers above, I would expect further announcements of further purchases - the fact that they have already bought ~ $ 300bn and real yields are 30bps higher than when they announced the purchases suggests that more buying is needed.
With the thought that the market should expect further aggressive UST purchases, its worth noting that 10 year UST real yields have moved from very oversold to very overbought in the space of 2 weeks, and are forming sell signals (Bearish Evening Star and RSI Divergence) - i.e. yields should now decline.
A temporary relieve of rising Real Yields is so important for risk assets. It would be a signal of less stress of funds moving from private sector investments to fund the US deficit and might finally suppress some market volatility. Watch the FED for more purchases and announcements of more purchases. This is wholly inevitable and should come as no surprise to the market given the existing and expected increase in future debt issuance trends.
Naturally, all of the above arguments hold for Eur, Japanese and UK debt - check the opening chart that shows the correlated moves of all the 10 year Real Yields.