personal views of a former fed trader

The Great Steepening

In the coming months a record amount of coupon Treasuries will flood the market even as demand for those securities appears to be faltering. Recent remarks from Chair Powell suggest quantitative tightening will proceed at a pace of $1t a year, double the annual pace of the prior QT. That could imply a process that quickly ramps up to around $700b in Treasuries and $300b in Agency MBS in annual run-off. At the same time, Treasury net issuance is expected to remain historically high at ~$1.5t a year. This implies that non-Fed investors will have to absorb ~$2t in issuance each year for 3 years in the context of rising inflation and rising financing costs from rate hikes. Even the most ardent bond bulls will not have enough money to absorb the flood of issuance, so prices must drop to draw new buyers. In this post we preview the coming QT, sketch out potential investor demand, and suggest a material steepening of the curve is likely.

Three Years to Shrink the Balance Sheet

Chair Powell has sketched out the contours of the upcoming QT program through a series of appearances. He noted at a recent Congressional hearing (1:48) that it may take around 3 years to normalize the Fed’s $9t balance sheet. The Fed estimates its “normalized” balance sheet based on its perception of the banking system’s demand for reserves. A conservative estimate based on the pre-pandemic Fed balance sheet size, and taking into account growth in nominal GDP and currency, arrives at a normalized balance sheet of around $6t. This would imply QT at rate of ~$1t a year, roughly twice the annual pace of the prior QT.

A decline from $9t to $6t over 3 years implies $1t a year in QT

Chair Powell suggested at his March press conference that QT would begin in May and look like the prior QT, which began with a ramp up and ended with a ramp down. The Fed’s maturity profile for Treasury coupons is front loaded and for Agency MBS is an estimated $25b a month pace. An aggregate cap that begins at $50b and ramps up to $80b would achieve $3t in QT in around 3 years. The Fed’s Treasury bill holdings are not strictly part of a QE program and may be managed separately. Note that Agency MBS prepayments are expected to be very low in the coming years as borrowers have less incentive to refinance. This may argue for a steady non-binding cap on Agency MBS reinvestments with some outright sales in the third year.

Agency MBS principal payments assumed to be $25b a month as per FRBNY estimates. Bills are excluded as they are usually handled differently.

Funding Uncle Sam

Over the next three years the market will have to absorb an unprecedented level of issuance as QT overlaps with historically high net issuance. QT does not change the size of the Treasury market but does change the composition of ownership. By the end of QT Non-Fed investors should hold $2t more Treasuries as Fed holdings decline by $2t. In addition, the overall size of the Treasury market is expected to increase by a projected ~$1.5t in net issuance a year. This projection may be conservative as Congressional spending has a history of increasing. Note that the exact maturity structure of the new issuance is determined at the discretion of Treasury.

Net Treasury issuance will remain historically high for the next few years (and very likely beyond)

Banks and foreigners (and Fed) have been the key marginal investors in Treasuries, but they are unlikely to increase their holdings going forward. Foreign private investors fund their purchases in the FX swap market, where rising borrowing costs from rate hikes are making dollar assets less attractive. Certain large foreign sovereigns may hesitate to further increase dollar exposure out of prudent risk management. With respect to banks, some large banks have indicated a shift in preference from securities to loans due to strengthening loan growth. QT will also mechanically shrink bank balance sheets so banks will no longer need to optimize returns by swapping reserves for Treasures.

The Fed, foreigners, and banks have been marginal buyers of Treasuries

Recent fund flow data also suggest waning demand for Treasuries. Data on bond ETF and mutual fund flows show a long streak of inflows has been broken by three straight months of outflows. This may be in part due to multi-decade high inflation readings and rising inflation expectations. Soaring prices across vast swaths of the commodity complex suggest that inflation could remain high and persistent. Bond prices may have to materially reprice to draw new buyers.

Three consecutive months of outflows in 2022

Finite Quantities

The price of any asset is not so much determined by perceived economic fundamentals as by supply and demand. This is particularly the case for safe assets like Treasuries, where vast swaths of issuance is absorbed by investors who are either not interested in returns or highly constrained in their investment options. The remaining discretionary managers live in a post-GFC world where balance sheet is scarce. When balance sheet is scarce, then there is only so much bank credit or repo financing available to fund positions and shape prices.

Anticipation of QT is already widening the spread between Agency MBS and Treasuries, but does not yet appear to affect Treasury prices. The supply and demand dynamics suggest that market may simply be slow to react. In that case, Treasury prices will also have to adjust downward, maybe by a lot.

23 Comments

  1. HJ

    Hi Joseph,

    What do you think about the relationships between US housing price, Inflation and anticipated steepening yield curve? Previous articles mentioned higher demand for hard asset yet higher long term rates also limited people’s purchasing power that eventually lowers demand, if speculation/investment owners are the majority that will be rates sensitive, is housing going to follow high inflation or high rates, or is this gonna be some sort of lags?

  2. Kyle

    I remember reading Greenspan’s memoir, mentioning at one point in 2001 that the Fed was worried about the increasing budget surplus, specifically its affect on the treasury market. As a result, the Fed was looking for other markets with which to conduct monetary policy.

    Oh boy, look at us now.

  3. Mani

    Hi Joseph- great piece.
    2 questions :

    1) will the 30 yr treasury rates also rise ? Or will the steepening be limited to the 2-10 yr curve ?

  4. Mark Anderson

    So the fed controls policy basically the 2yr rate and the market determines the further dated maturities. We are practically inverted or very tight on the 2’s 10’s spread and the yield curve. So is this saying the market is pricing in hikes in the short term and then rate reductions in the long term. Isn’t this a great time to buy the long end of the curve? The fed has projected to push the fed funds rate to 1.75% by the end of 2022. Wouldn’t this make a 10 year at 2.1% a steal?

    • Martin Tiburón Del Toro

      Seems you were right, but a little early. Most of FinTwit is now saying buy long term Treasury bonds or ETFs, such as TLT.

  5. Vik

    Nice piece Joseph – I have a similar question as Mani. How do you see the Fed selling off different maturities i.e. will they sell off more long dated vs short dated bonds? Will they coordinate with Treasury to ensure the mid/long end rises much more than the short end thereby steepening the curve?

    Everyone’s looking at the inverting yield curve as a recession signal. If the Fed successfully steepens the curve does that suggest we may avoid recession in the next couple of years?

  6. John Ahearn

    With respect Joseph, how does a treasury price rise to 4% (picking a number out of thin air) not end with a collapse in risk assets which must re price their risk premium and high yield debt?

    And where do you think the trillions in flows are going to go if not into the waiting arms of long duration risk free assets?

    You mention yourself that balance sheet space is scarce. But in what world does a bank look on its balance sheet in 2022 and decide to cut tier 1 capital before cutting other risk assets with higher balance sheet costs if what you say comes to pass?

    Treasuries don’t exist in isolation. The debt and leverage in the market is substantial, and I fail to see how after 40 years of downward pressure on Yields, it is going to suddenly end now without causing massive casualties in every other asset class on the planet.

    I think what we will see is a bifurcation where those with access to short term secured funding will hoarde collateral of various tenors that they can use to swap for liquidity on demand that is paying them a positive yield as they re evaluate the capital on their books that eats up a larger portion of their balance sheet.

    Only in a land of excellent sustained growth can I see treasuries fall as you described. And I do not believe we have growth that will be able to withstand current conditions by the time Q2 ends.

    Perhaps it is in the health of growth that we currently disagree? In which case, I would more easily be able to see things your way.

    Respectfully,

    • Adam

      Also, if QE was good for risk assets and QT is potentially bad for risk assets maybe the fed is creating their own market? As in don’t treasuries experience demand from non-banks when other assets are falling? TLT was +34% in 2008

    • Richard Sharp

      This is a thoughtful and excellent reply. Found you on Twitter, too:-)
      Question: How high do you expect us10y yields to go? What’s the ceiling before something breaks?

    • Anonymous

      I completely agree. I think the market perceives QT akin to raising short term rates and in that sense once you do enough of that it actually puts downward pressure on long term yields. People perceive the QT as growth negative event. I know there is a debate on short term supply/demand (us govt profligacy) dynamics outweighing long term economic fundamentals in investors’ calculus, but I simply don’t think we are at that point yet.

      At the end of the day I think the only thing which will potentially crash treasury markets is a Fed that is losing credibility in fighting long term inflation. Another person also commented here about foreigners always need to recycle dollars and they need the exports for their own gdp sustenance. That is a good point also.

      Cash investors I think will easily sweep up ten year at 3pc than wait the fed to catch up the short term to 2pc. You know they’ll crash something before they get there, we’re officially only at .25 right now regardless of what Eurodollar and feds funds futures are pricing in.

  7. fjcruiserdxb

    I don’t see any drop in demand from foreigners as collateral shortgae still remains unaddressed. As long as exports to US keep going and US trade deficit doesn’t shrink, all the dollars foreigners earn need to be plowed back into US treasuries. Foreigners will happily invest in longer maturities to get a little extra yield. We can see that demand for short term bills is still strong since they trade at a heavy discount to RRP. With attitude to risk dropping (inverted yield curve making it harder for banks tomake money), even domestic banks will be big buyers of treasuries.

  8. John

    Say loan demand slows with higher rates. Why do banks not just swap reserves for Treasuries leaving asset side of bank balance sheets unchanged. I can see why that may be a problem given shape of yield curve but its not obvious to me why bank balance sheets need to shrink in aggregate based on QT. Like you say its just an asset swap changing composition of money.

  9. Roquentin

    So, why this didn’t happen the last time?

  10. Shane

    Hi Joseph
    I have a hunch that the Fed winding down their balance sheet might not steepen the curve but could cause a big correction in the market and have people rush towards buying long term treasuries, further pushing longer term rates down.
    So we’re in a environment of supply shocks and lockdown supply chain woes, and the Fed thinks that QT will fix those two issues when in fact it might only be adding more disruption to the an already unstable and chaotic market.
    In any case we’ll have more QE down the line five years from now, anything that happens from now till then is not too relevant imo.

    • Martin Tiburón Del Toro

      Here we are four months later, the curve is flat and there is a large appetite for long term treasuries. Seems you were on to something.

  11. Bdon

    How do I find the Treasury net issuance of $1.5 trillion?

    • Martin Tiburón Del Toro

      I assume the $1.5 trillion, which is a guess, is basically the annual deficit. The fiscal 2022 deficit is now expected to be less than $1 trillion, less than 2019’s deficit. If you search, you can find a lot of government agencies that put out reports on Treasury auctions, tax collections, expenditures, and deficit. The data is updated monthly or even more frequently.

  12. Anonymous

    Based on what was recently announced Joseph was on the money! Also sounds like immediate sales of agency mortgages are being considered.

    • Martin Tiburón Del Toro

      Four months after publication, it seems, to me, that Joseph has a lot wrong.

      The 2022 deficit is coming in less than 2019’s deficit, which I think should decrease Treasury issuance. The most recent auction saw a lot of foreign buyers in a possible flight to safety, meaning no problems finding buyers.

  13. Herman

    Very interesting…and even more interesting to see so little replies/comments

    • Herman's Friend

      Here’s a reply. Hi Herman.

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  15. David

    A question along the inflation line given that I just read your book Central Banking 101. What does this bout of inflation mean for MMT?

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