The venerable UBS floorman asks (and answers) an interesting question. With the re-institution of the payroll tax and higher level rates and with spending lowered by sequestration, will the Treasury need to offer fewer bonds? And if so, will the Fed remain steadfast in its purchasing 'size' (good for bond bulls since secondary demand will increase) or reduce its 'size' to meet the lower monetization needs of the Treasury (bad for equity bulls since flow is all that matters.) Thoughts below...
Via Art Cashin, UBS,
Do Fewer Bonds And A Steadfast Fed Equal Even Lower Rates? – That was part of the question we posed last Tuesday. If the Fed's refunding needs temporarily shrink (fewer bonds issued) and the Fed keeps buying at its announced pace ($85 billion a month), won't that drive bond prices higher and send rates even lower? Here's how we postulated that early last week:
There May Be More Here Than Meets The Eye – FOMC Version – While most of the media will be carefully monitoring every phrase, nuance and hint of body english going into – and out of – Wednesday's FOMC meeting; traders will also be looking elsewhere. That elsewhere is the report of the U.S. Treasury's refunding needs for the coming quarter.
Up until now, a rather profligate group (both sides) in Washington has been spending money hand over fist. To cover that spending, the Treasury has been issuing and selling bonds at a frantic pace. As they try to stimulate the economy, the Fed has been buying those bonds almost as quickly as the Treasury can grind them out.
Traders wonder if things have changed. With the re-institution of the payroll tax and higher level rates and with spending lowered by sequestration, will the Treasury need to offer fewer bonds? Would such a limited supply force the Fed to be more aggressive just to buy the same $85 billion a month? What would that do to the bond market? What might it mean to yields? Traders may get the answer Wednesday morning – long before the FOMC statement at 2:00.
Well the answer's in and several very smart people are beginning to explore the question. Here's a bit of what David Kotok wrote over the weekend – alluding to a Jim Bianco piece:
Let's go a step farther. Bianco points to Treasury officials' projections for borrowing in 3Q 2013. They estimate that borrowing at $223 billion. That number is much lower than its counterpart in any of the years since the financial crisis triggered the new Fed QE policy. If we assume that the Fed continues its present $85 billion a month QE policy in 3Q, we can argue that the combined actions of the Fed and the Treasury will mean no net impact on the publicly held Treasury supply. Half a year will go by without any net new Treasury debt being placed in the market.
New debt issuance since the financial crisis has been lower than in prior comparative periods. In the combined third-quarter projection and second-quarter realization, we see, as a result of declining net issuance of federal debt with market pressures reduced by hundreds of billions of dollars. At the same time, Fannie Mae and Freddie Mac are still embroiled in their restructuring debate, and their issuance, too, is much less robust than it was prior to the financial crisis.
Where are we going with this thought? Well, it appears that, while the Fed continues to absorb new issuance of federally backed securities, the amount of new issuance is declining on a net basis. That helps explain lower interest rates. Simply put, the price goes up when you have less of something produced and more of it purchased. When it comes to bonds, that means that yields go down.
Next, David's partner, Bob Eisenbeis, approached the reduce refunding from a slightly different level:
Two critical concerns and issues arise.
First, it won’t be long before only 30% of US Treasury obligations will be in the hands of private citizens and domestic financial and other institutions. This trend, combined with recent evidence that the US Treasury may actually begin to pay down the outstanding public debt, portends a squeeze on the outstanding supply of Treasuries, bidding up of their prices, and continued downward pressure on Treasury rates across the term structure.
Second, the squeeze will force institutions into less liquid financial instruments in their quest for liquidity and collateral. Fed studies the last time there was concern during the Clinton administration that there might be little or no outstanding public debt concluded that only mortgages and mortgage-related securities had markets deep enough and liquid enough to provide a potential substitute.
Knowing, as we do now, just how fragile mortgage markets and the market for mortgage-related securities can be, we question whether such instruments could be an effective substitute without substantial ex ante haircuts.
Net/Net, given diminished new supply of bonds, the Fed may have to adjust course or risk, driving the yield on the ten year Treasury below 1%.