Intervening Oneself Out Of Quagmire?
By Elwin de Groot, head of macro strategy at Rabobank
Intervening Oneself Out Of Quagmire?
Yesterday’s market moves again showed that jawboning and temporary interventions are rarely enough when the underlying problem is fundamental.
As a “thank you” for Trump’s last-minute intervention to reduce joint US-South Korean military drills – and his claim to have spoken with Kim Jong Un – Pyongyang launched around 10 ballistic missiles on Thursday, according to South Korean news agencies. The message was clear: action versus words. Developments in the Middle East, where Iran has effectively defied US military power, may only have reinforced North Korea’s conviction that its nuclear missile programme gives it an edge even Iran still lacks. The broader ramifications are unsettling.
Markets told a similar story. The benchmark US 10-year Treasury more than gave back the gains made the previous day, while the 30-year long bond retraced over 7bp after Thursday’s 10bp rally, which followed Treasury’s announcement that it would at least double long-dated bond buybacks from 9 September through 4 November.
The price action may matter more than the amounts involved. The additional purchases total only about USD 14bn in the current refunding quarter – a rounding error next to a roughly USD 32trn Treasury market and federal debt now above USD 40trn. Nor is this quantitative easing: Treasury must finance buybacks by issuing other debt. The programme can improve liquidity in off-the-run bonds and temporarily reduce the duration dealers and investors must absorb, but it neither cancels debt nor changes the deficit path.
That distinction explains why Thursday’s long-bond rally should not be extrapolated – and why part of it has already faded.
In the short run, supporting the back end can work. It reduces pressure on term premia, improves dealer balance-sheet capacity and makes outright shorts in long Treasuries riskier. But it also increases reliance on continued bill demand, with no certainty that future stablecoin issuance can offset that exposure for foreign holders. If borrowing needs remain large, Treasury may eventually have to return to greater coupon issuance – or accept higher funding costs.
The medium-term implication is therefore less “lower yields” than “a more managed yield curve”. Call it YCC-light. The Treasury has shown sensitivity not only to poor liquidity, but also to the economic and political consequences of rapidly rising long-term yields. Thirty-year rates above 5% feed into mortgages, corporate financing, equity valuations and, through higher interest costs, the deficit itself. That creates a feedback loop: higher yields worsen the fiscal outlook, which warrants a larger term premium, which raises yields further. Wednesday’s intervention interrupted that loop; it likely did not break it.
The episode also risks blurring the line between debt management and monetary policy. If investors conclude that Treasury will adjust issuance or buybacks whenever long yields rise too quickly, that creates an implicit “Treasury put”. It may suppress volatility for a while, but it could prove self-defeating. Easier financial conditions from lower long yields sit awkwardly alongside above-target inflation, complicating the Fed’s task, as minutes show several policymakers were prepared to raise rates in July. The Treasury may be insuring the market against a tail event just as the Fed tries to keep conditions restrictive.
The dollar’s negative reaction is therefore revealing. Normally, lower Treasury yields weaken the currency through the interest-rate channel. This time, gold and crypto also rallied, suggesting concern about fiscal credibility and the perceived management of borrowing costs. Yesterday’s price action reinforced that message: both the dollar index and gold have extended Thursday’s moves. Could the end-result soon be unchanged long-term yields, but a weaker dollar?
Of course, the dollar still benefits from deep capital markets, strong nominal growth and reserve-currency status. But those advantages are less reassuring if foreign investors believe they are being asked to finance widening deficits while the authorities lean against the resulting rise in term premia.
This week’s geopolitical backdrop sharpens the dilemma. Higher oil prices and uncertainty around Iran and the Strait of Hormuz add an inflation premium; the 5y5y US inflation swap forward is now close to its May peak even though headline inflation has fallen by almost a percentage point since then. This comes just as fiscal supply tests investors’ appetite for duration. The Treasury can address market plumbing, but it cannot buy back geopolitical risk, inflation risk or fiscal arithmetic.
The Friday takeaway is that Wednesday’s announcement matters mainly as a signal. It tells investors the authorities are unwilling to leave the long end entirely to its own devices. That may intermittently cap yields and curve steepening. Yet if every rise in long yields elicits more bills, larger buybacks or smaller long-bond auctions, the adjustment may migrate elsewhere: into front-end funding costs, inflation expectations, gold – or the dollar. The market may have been calmed, but it has learnt where Treasury’s pain threshold lies.
That said – and allowing for possible European bias – investors watch fundamentals not only in absolute terms, but also relative to other regions and asset classes. This week’s widening of the French spread over German Bunds serves as a case in point: a clear warning that markets are focused on the upcoming presidential election and France’s structural challenges.
Finally, the speed of technological change seems to be widening the gap between Europe and the US. The geopolitical overlay is pungent and spicy: for Europe, it smells of rising tensions with major trading partners in the coming months.
China has been warning European trading partners already through several channels that it willing to play hardball to stave off intensification of European trade defense measures. Another example are news reports yesterday suggesting that the US is preparing to force the Netherlands to ban ASML from selling to China entirely. As both Republicans and Democrats seem to be on the same page with potential legislation backing such a move, this raises the risk of coercion.
Perhaps these pressures will push Europe towards next steps, such as integrating capital markets. If so, that would be fundamental change. For now, it remains mostly words in Europe too.