Timing The “Crossover Point”: The Fed Will Soon Monetize The Entire Fiscal Stimulus Package… What Happens Then April 13, 2020 Jordan Financial
As we noted late last week, the Fed’s money printer has been going brrrr in overtime, and in the past month alone, Powell & Co. has purchased nearly $2 trillion in Treasury and MBS securities, far more than during any of the previous QE episodes (either in the first month or their entirety)…
… which together with the Fed’s POMO schedule which sees the Fed purchasing another $225BN in securities this week…
… will push the Fed’s balance sheet (currently at $6.1 trillion) to $6.4 trillion by next Friday, up more than 50% in the span of just weeks.
That’s just the beginning, because as we showed two weeks ago, BofA strategist and former Fed guru, Mark Cabana expects the Fed’s balance sheet to double to $9 trillion by the end of the year.
What does this mean for Treasury issuance? Well, for one thing it means that the Fed will monetize not only all the debt issuance for 2020 that was scheduled before the coronavirus pandemic broke out, but also the entire fiscal stimulus package (currently $2.2 trillion, soon $3+ trillion). Which is hardly a surprise: last week the Bank of England became the first bank to officially announce it would openly monetize the UK’s deficit. In other words, the central bank and the Treasury are now one and the same, which also means that helicopter money has arrived, first in the UK and soon everywhere else.
It also means that, as DB’s Stuart Sparks puts it “these are administered markets” (or perhaps “administerrrrrred” markets).
Yet while the Fed has unleashed an unprecedented buying spree across the curve, traders are starting to ask when and how will markets price in a “crossover point” when there is more supply than demand (if such a thing is possible), potentially resulting in a violent bear steepening in the yield curve and a spike in long-term yields as the Fed loses control over long-term inflation expectations.
Commenting on this, DB’s rates strategists write that the narrative for bearish curve steepening is rooted in the idea of a crossover point at which the duration impact of additional Treasury supply exceeds that of demand stemming from Fed QE purchases. This is particularly true in the long end, where the Treasury is still expected to begin 20y issuance in the May refunding. The “crossover” argument is illustrated on the chart below: coupon supply net of Fed purchases is likely to turn positive during Q3, even if the Fed monetizes the entire fiscal stimulus package as it currently stands.
That said, the crossover argument is inherently a flow argument, rather than a stock argument. To mitigate fears that the deluge of Treasurys – now that helicopter money has been unleashed – will lead to a chaotic spike in long-rates, Deutsche Bank writes that an immediate issue with the flow argument that increasing Treasury supply will push yields higher and the term premium steeper “is that it ignores the flows between the present and the time at which this crossover occurs.” That is, large purchase volumes at higher than market WAM should flatten the term premium and push yields lower until the crossover point. Yields might rise and the term premium steepen, but from lower and flatter levels.
At the same time, the Fed’s thought process around QE is inherently more stock-based (an argument that the Fed lost long ago when it was demonstrated conclusively by the like of Goldman and others that only the flow matters): QE “permanently” reduces the stock of risk free government debt, which should cause that government debt to richen. In order to enhance returns, private investors are then obliged to extend duration, flattening the term premium. When the term premium is flat, investors must move out the risk spectrum to enhance returns. This is the Fed’s portfolio balance channel.
Deutsche take a middle ground, and notes that pragmatically, one would expect the effects of large asset purchases to be cumulative, and to occur at a lag. For this reason QE is something of a hybrid between stock and flow. Intuitively, Fed purchases of, say, $100 billion/month should have a different impact on the market if they were preceded by a period in which the Fed bought $2 trillion in total than they would had the Fed bought nothing previously. Here DB is quick to note that, at its projection of QE demand, the Fed will have fully monetized the first three phases of fiscal stimulus totaling around $2.2 trillion. Likewise the bank expects Fed purchases to increase to absorb any “phase 4” stimulus as is currently being debated in the US Congress.
In short, without the Fed actively monetizing US debt, the long end would have disconnected long ago.
A second issue is that there is still a reasonable amount of uncertainty about the magnitude of flows on both the supply and demand sides. Let’s start with the supply side.
While a fourth installment of fiscal stimulus of $1 trillion or more would clearly add to potential supply, it is somewhat less clear where on the curve it might come. Specifically, there is a possibility that the Treasury might elect to delay its inaugural 20y issue due to poor liquidity and stretched dealer balance sheets. According to DB, the entire 2040 maturity sector is trading extremely cheap to the fitted curve (chart below).
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Poster Comment:
Charts at source.