One week ago, we suggested that what was behind last week's surreal market moves in the aftermath of Wednesday's FOMC - which saw an unprecedented plunge in yields despite the Fed's hawkish pivot - had little to do with the Fed pronouncement and much more to do with Friday's huge quad-witching op-ex as well as the market's stretched, one-sided technicals which included a record short bias among treasury traders, which forced a painful squeeze, sending prices sharply higher and sparking a buying frenzy in growth names.
But what if most of the recent move in US treasuries not only had little to do with the data or the Fed, or with the positioning technicals of the market? That's the hypothesis proposed by Deutsche Bank's head of credit, Jim Reid, who muses that If true, "the danger is that the market and authorities over interpret the macro conclusions and react the wrong way."
So what should one focus on? Well, according to Reid, what may be at play is the relative lack of recent Treasury bill issuance as they ran down their TGA balance at the FED by nearly a Trillion dollars from the early year peaks, which in turn has had a significant impact on supply/demand dynamics and hence, price.
As the credit strategist elaborates, "there are all sorts of distortions at the moment that getting proper macro signals from the bond move is incredibly tough." Reid, who recently co-authored a paper warning that the US is facing unprecedented inflation, muses that while "it could be that we do have a big inflation problem or it could be that inflation is transitory" in either scenario the bond market might not be the best place to settle the argument at the moment. In fact, Reid warns, "if there is more inflation than the transitory crowd believe, the current technical conditions of the bond market might make the eventual correction in yields, when some distortions fade, even bigger."
To demonstrate his point, Reid then presents the following chart co-created with fellow DB credit strategist Steven Zeng,which shows Treasury net issuance versus Fed purchases, both using a 3 month moving average: "As we can see, Treasury net issuance has collapsed over the last 2-3 months (particularly bills) as a result of the Treasury's drawdown of TGA cash, with the current 3-month moving average at $77Bn, the lowest since just before the pandemic and also around a third of the level seen in January this year.
Fed purchases have been taking down all the net supply of late - a rarity in recent years as the chart shows even with QE. And given that demand from other players like banks has been very high - as these tend to correlate closely to deposit holdings...
... it’s easy to see why there might have been a squeeze.
In any case, the fact that issuance is below pandemic levels even though deficits are far, far higher isn’t sustainable and as Reid concludes "these conditions are unlikely to last" so as a result, the DB credit expert warns that "we'll be back to the data being important, one way or the other, soon"