QE’s Fading Legacy Moving Long Yields Higher

Summary

• The legacy of the Fed’s QE is fading in the bond auctions
• For the first time in several years, SOMA did not and will not participate in any of the September or October Treasury auctions
• The Treasury has to refinance SOMA maturities with the issuance of new market debt or run down its checking account balance at the Fed
• Though quantitative tightening does not increase the public debt, it puts supply pressure on the market
• This post is an excerpt of our Sep 23rd post, The Gathering Storm In The Treasury Market 2.0

We suspect our Sep 23rd beast of a post,  The Gathering Storm In The Treasury Market 2.0,  was TLDR – Too Long, Didn’t Read.  One famous blogger said of it, “This post is so big, you can see it from space.”   We feel it was an important read for any market watcher as the 10-year T-Note yield is the most important price in the world.

In that post we which laid out why several factors which have kept U.S. long-term interest rates low and repressed term premium suppressed are fading,

Impatience and ADD equals missed opportunities,  as we wrote in the summary bullet points,

• The yield curve is flat for technical reasons, and we believe term premia will increase
• We expect a measured move in the 10-year Treasury yield to 4.25 to 4.40 percent, much sooner than the Street anticipates  – GMM, Sept 23rd

That was just before the 10-year yield broke out.

We are going to slice and dice the that post for an easier read for those of us use to 140 280 characters.

We named four significant factors that were changing and set to move long-term interest rates higher and increase the term premium.   This post extracts and focuses on the fading legacy of QE in the bond auctions

Posted on September 23rd

We now examine four changing structural factors that have created a favorable technical environment for the U.S. bond markets, which have kept long-term interest rates abnormally low and pancaked the yield curve:

1. The ballooning of the budget deficit during economic expansion;
2. QE and its diminishing legacy of reinvesting maturing notes and bonds;
3. Borrowing from the social security trust funds,
4. Globalization

The Diminishing Legacy Of QE

We constructed the following chart to illustrate the schedule of maturing Treasury securities by month, held in the Fed’s September 12th SOMA portfolio.

In the current month of September, for example, $19 billion of Treasury securities mature, but the total falls below the $24 billion monthly quantitative tightening cap (purple line) leaving zero SOMA cash available to reinvest and participate in the Treasury auctions.  The $19 billion will not be reinvested and is reflected in the red bar.  The Treasury will be forced to plug the gap with new market borrowings or rundown its cash balance at the Fed.

The same dynamics hold for the roll-off of the SOMA MBS portfolio, where the cash balances at the Fed of the government-sponsored enterprises (GSEs) are reduced when mortgages run-off and not reinvested.

September To Remember

September will be the first month in several years where the SOMA will not participate in any of the notes, bond, FRN, or TIPs auctions.  Recall our early assertion, SOMA’s cash reinvestment of its maturing Treasuries back into the auction does not increase in the public debt.

The same holds for October, when the QT cap steps up to $30 billion per month, as $24 billion of Treasuries mature.

In November, $59 billion of SOMA Treasuries mature, of which $30 billion (the QT cap) will not be rolled over (red bar) and drained from the financial system, with the remaining $29 billion (green bar) in cash used as noncompetitive bids in the variety of notes, bonds, FRN, and TIP auctions.

Some argue SOMA’s impact on the auction and markets is de minis.  We disagree.

Asymmetric Effects Of QT

We need to think more about this but our first impression is the economic effect of quantitative easing, and quantitative tightening is not symmetric.  Because of the difference on the liability side, QT appears that it will be more direct, more onerous than expected, and will be quicker in its economic impact than QE.

Moreover, QE enabled the government to issue the debt it now has to pay back to the Fed or forced to roll by more issuance of marketable debt.

QE has blurred the lines between fiscal and monetary policy.   Quantitative easing (QE) has  just been “turbocharged fiscal policy in drag with a lag.” Great hip-hop line, no?

Portfolio Switching

Research at the Fed from last year expected a symmetric decline in demand for risky assets under quantitative tightening relative to QE.   The action in emerging markets this year appear to confirm, at least, in part, their analysis.

Carpenter et al. (2015) examined data from the Financial Accounts of the United States and found that the household sector—which in this dataset includes sophisticated investors such as hedge funds—was the predominate seller of Treasury securities to the Federal Reserve during its large-scale asset purchase programs, and that the household sector rebalanced its portfolio toward corporate bonds, commercial paper, and municipal debt and loans.  If we lean on their results and apply them in reverse—that is, reverse the actions that were found to occur during that earlier period so as to hypothetically mimic a period of Fed securities redemptions—then we would expect the household sector, as defined in this context, to rebalance its portfolio away from the riskier assets and back towards Treasury securities.  – Federal Reserve Board

Reduction In SOMA Treasury Portfolio 

The black line in chart above illustrates the decrease in the SOMA Treasury portfolio over time as securities roll-off.

Some argue that the stock of excess reserves are declining too fast, down 18 percent since QT began causing the Fed Funds rate to consistently trade at the top of the 25 bps target range.  Consequently, the Fed will be forced to end its balance sheet reduction sooner than the markets think.

A plausible scenario.   However, why not just stop paying or further reduce the interest rate on excess reserves (IOER), which will force reserves back into the Fed Funds market putting downward pressure on the rate?

If we had to guess,  QT ends in June 2022 when the SOMA Treasury portfolio hits $1.5 trillion and the MBS portfolio around $1 trillion.  We suspect, however, the glass will begin shattering long before then, forcing the Fed to reverse course.

…before the financial crisis hit, growth in the Federal Reserve’s securities holdings was in line with growth in nominal GDP.  In particular, between 1990 and 2007, the Federal Reserve’s securities holdings totaled a fairly steady share—about 5 percent—of nominal GDP.  – Federal Reserve Board

A $2.5 trillion SOMA portfolio in June 2022 would be approximately 10.5 percent of GDP,  more than double its holdings before the GFC.

History Of SOMA Participation In Treasury Auction

Our next chart illustrates the SOMA participation in every Treasury auction since September 2009, which was financed by the sum of its maturing securities during each particular month.

The green bars represent the SOMA percentage takedown of the total amount of securities issued during the auctions, and the black line is the corresponding 10-year Treasury yield on the date of each auction.

Operation Twist

The Fed engaged in “Operation Twist” between September 2011 and December 2012 (two red bars) to bring down long-term rates.  It sold shorter-term securities in its portfolio to purchase long-term Treasuries.  It appears just the anticipation of the program reduced yields as traders began front-running the Fed.

Interest rates began to spike as soon as the SOMA ran out of maturing securities and stopped participating in the auctions.   That is what concerns us now.

The SOMA’s participation in auctions going forward will be sporadic, at best, which could put upward pressure on rates and further crowding out borrowers as the Treasury is forced to issue more marketable securities.

The following is the Treasury press release of the results from the August 30-year bond auction.  Notice the SOMA took down almost 12 percent of the total outstanding bonds issued.

SOMA Participation Does Not Increase Public Debt Stock

It is important to realize the net stock of Treasury debt does not increase with SOMA participation in the auctions as the cash is derived from maturing securities.  Nevertheless, is does allow size of the auctions to increase.

Declining SOMA Auction Participation 

Our next chart shows the recent past and future SOMA participation in the Treasury auctions through 2019.  The key takeaway here is that the SOMA will be active in the auctions in only five of the next 16 months,

We believe the bond market has not fully focused on the diminishing participation of the SOMA in the auctions going forward.   It now has the data and should be on traders’ radar, causing upward pressure on long-term interest rates.   We could be wrong in our analysis of how powerful the impact SOMA’s auction participation is on markets, however.