In An Unexpected Outcome, Trump Tax Reform Blew Up The Treasury Market

Over the past week we have shown on several occasions that there once again appears to be a sharp, sudden dollar-funding liquidity strain in global markets, manifesting itself in a dramatic widening in FX basis swaps, which - in this particular case - has flowed through in the forward discount for USDJPY spiking from around 0.04 yen to around 0.23 yen overnight. As Bloomberg speculated, this discount for buying yen at future dates widened sharply as non-U.S. banks, which typically buy dollars now with sell-back contracts at a future date, scrambled to procure greenbacks for the year-end.

However, as Deutsche Bank's Masao Muraki explains, this particular dollar funding shortage is more than just the traditional year-end window dressing or some secret bank funding panic.

Instead, the DB strategist observes that the USD funding costs for Japanese insurers and banks to invest in US Treasuries - which have surged reaching a post-financial-crisis high of 2.35% on 15 Dec - are determined by three things, namely (1) the difference in US and Japanese risk-free rates (OIS), (2) the difference in US and Japanese interbank risk premiums (Libor-OIS), and (3) basis swaps, which illustrate the imbalance in currency-hedged US and Japanese investments.

In this particular case, widening of (1) as a result of Fed rate hikes and tightening of dollar funding conditions inside the US (2) and outside the US (3) have occurred simultaneously. This is shown in the chart below.

What is causing this? Unlike on previous occasions when dollar funding costs blew out due to concerns over the credit and viability of the Japanese and European banks, this time the Fed's rate hikes could be spurring outflows from the US, European, and Japanese banks’ deposits inside the US. Absent indicators to the contrary, this appears to be the correct explanation since it's not just Yen funding costs that are soaring. In fact, at present EUR/USD basis swaps are widening more than USD/JPY basis swaps.

According to Deutsche, it is possible that an increase in hedged US investments by Europeans could be indirectly affecting Japan, and that market participants could also be conscious of the risk that the repatriation tax system could spur a massive flow-back into the US, of funds held overseas by US companies

In fact, one can draw one particularly troubling conclusion: the sharp basis swap moves appear to have been catalyzed by the recently passed Trump tax reform.

  • Corporate tax reform in the US

The United States House of Representatives and Senate recently passed a tax reform bill that lowers the corporate tax rate from 35% to 21% starting 2018. Lowering corporate taxes would likely accelerate the pace of Fed rate hikes, which could trigger a shift from dollar deposits to Government MMFs. Revisions to interest tax deductions would encourage companies to repay corporate bonds and could spur a decrease in dollar deposits (however, demand to bank loan could also weaken).

  • Repatriation tax system

The tax bill also includes the abolishment of taxation (currently 35%) on dividend payments from overseas subsidiaries. However, overseas subsidiaries' retained earnings would be subject to a one-time tax. It is expected that this repatriation tax system would result in reserves held overseas by US companies (we estimate 90% are USD-denominated) flowing back into the US. This could create tighter conditions for USD financing outside the US.

Which leads to a bizarre outcome, that while the GOP tax reform may benefit corporate America, it appears set to punish America itself as buyers of US Treasurys suddenly require far greater yields to offset the surge in funding costs!

* * *

Whatever the cause behind these sharp funding shortages, one thing is clear - dollar funding costs (FX hedging costs) for both Japanese and European insurers and banks to invest in US Treasuries are surging (with Japanese buyers and reached a post-financial-crisis high of 2.35% on 15 Dec. And in terms of practical implications for the treasury market this means that, all else equal, marginal demand for US paper is about to plunge for one simple reason: the FX-hedged yields on US Treasurys have plunged to (negative) levels never seen before (unless of course foreign investors buy US Treasurys unhedged).

To demonstrate this point, the chart below from Deutsche Bank shows the yields on currency-hedged US Treasuries from the perspective of Japanese investors. Japanese financial institutions tend to use 3-month FX forwards when they invest in hedged foreign bonds. Annualized hedge costs have recently risen to 2.33%, which means that investments in 10y US Treasuries result in virtually no yield. Furthermore, yields from investment in shorter than 10y US Treasuries would be less than JGBs and result in negative spreads. This means that unless funding costs slide, Japanese buyers will simple pick JGBs over TSYs, eliminating one of the biggest sources of Treasury demand in receng years.

There is another consideration: as Deutsche Bank notes, whenever it is time to roll over a hedge, financial institutions need to decide whether to (A) sell US Treasuries or (B) hold them as unhedged foreign bonds. Engaging in (B) on a large scale would be difficult unless the institution's outlook calls for yen depreciation. After implementing (A), institutions should then choose to invest in high-yielding US MBS (high interest rate risk), medium- to low-rated corporate bonds (high credit risk), European and other sovereign bonds, or to reinvest in JGBs.

Moving away from Japan, and looking at Europe one finds an even more dramatic slide in hedged TSY yields, which net of hedge costs have plunged to -0.6%, by far the lowest - and most negative - on record, something we highlighted yesterday in "There's Never Been A Worse Time For A European Investor To Buy US Treasuries" .

The conclusion is that as a result of the recent surge in funding costs, seemingly in response to the nuances of Trump tax reform as explained above, suddenly buying US Treasurys is no longer an economic option for virtually all foreign buyers! Needless to say, something will need to change because if funding costs stay where they are, yields across the curve will have to jump for US Treasurys to once again be an attractive purchase for foreign buyers, which as a reminder comprise the majority of TSY buyers in recent years.

What is the outlook? Some parting thoughts from Deutsche, which writes that according to the chart below, fundings costs will likely continue widening as the Fed raises interest rates.

DB then also warns that the repatriation tax system that was just passed into law, coupled with ongoing Fed rate hikes, will indirectly result in the widening of dollar funding conditions in and outside of the US. And the punchline: if these indeed continue to widen, and US long-term interest rates stay at a low level, "this would restrict investments in US Treasuries by Japanese financial institutions relying on short-term dollar funding." This could then lead to a sharp move higher in US yields - and rates- as the US finds it needs an aggressive increase in foreign demand to finance the widest US budget deficit in years. 

In other words, by pounding the table on - and recently passing - tax reform, Donald Trump appears to have sown the seeds of the equity market's own destruction, because remember that the one thing that can bring the house of manipulated cards down faster than you can say covfefe, not to mention burst the equity bubble, is a sharp move higher in long-term yields, rates, and ultimately - inflation.


Ghost of PartysOver YUNOSELL Wed, 12/27/2017 - 14:18 Permalink

As screwed up as the Global Bond markets areas a result of all the QE, currency printing and CB Bond purchases,  it will not take much to trigger a realignment/reset to true price discovery.  True price discovery, is that still possible?  So can't blame this on the tax package.  Any event was going to create some short term havoc which is good as it means short term trading profits.

In reply to by YUNOSELL

earleflorida Antifaschistische Wed, 12/27/2017 - 18:05 Permalink

interbank transactions reduce the transparency of commercial banks balance and off-balance-sheets data and complicates the measurement of a commercial banks liquidity and solvency rates for prudential purposes.systemic risk is a [concern] only in a 'decentralized environment' in which 'BANKs'[!] incur credit risk in their mutual transactions.remember that the FRB system knows all,...but [NOT] all ?, in which the TBTFs considered detremental for their survival in a cut-throat interbank (FX) invironment Note: the FRB System has been accomodative for nearly a decade as the 'Lender-of-Last-Resort' (LLR & ILLR?) 'Int'l Lender of Last Resort' which is contrary to all the Sciences of Financial dogmatic principles.LLR is only to be 'TEMP' for exogenous/endogenous financial crisis and to be used wisely when malfeasance was primarily the cause and effect of the crisis.ALL Banks in america are exemp t?!? Gifted TBTF status and look at what has happened because of a congress that has shrugged its fiscal responsibilities,...---[and], to a privately owned CB!! 

In reply to by Antifaschistische

zzzz88 Wed, 12/27/2017 - 14:20 Permalink

no one denied that this is a manmade everything everywhere every cycle bubble. central banks keep it going for almost 10 years. but the turning point is here--market can not acknoledge the central bank rate anymore. in usa and china, many borrowed money at a much much much higher rate than the central bank rate. this will force the interest rates go higher and higher, no matter central banks want it or not. so the bubble game is ending sooner than most imaged. 

JibjeResearch Wed, 12/27/2017 - 14:25 Permalink

The Corporation tax decrease will result:1. Stock buy back (very likely) or2. More pay for employees (very unlikely or very small, or big bonus for executive is highly to happen)3. Repay debt (highly unlikely)4. Research and Development (somewhat likely)5. Hedged investment (very likely)6. Dividend (somewhat likely) If money ends up in the hands of the workers, expect the economy to rise and interest rate rise.  If that happens, bond's price crashes.Expect inflation.  Don't expect Metal's price to rise much.  If anything rises, it'll be cryptocurrencies because people want to hedge against central planners. Best wishes :)

buzzsaw99 Wed, 12/27/2017 - 14:36 Permalink

...this time the Fed's rate hikes could be spurring outflows from the US, European, and Japanese banks’ deposits inside the're god damn right it is.  makes perfect sense. 

buzzsaw99 Gulfcoastcommentary Wed, 12/27/2017 - 15:16 Permalink

i am reticent to debate this topic with you because i suspect you don't understand it. i will say this though. as the fed has raised the overnight banks have not followed suit and raised the rate they pay on the $13T entrusted to them by depositors much at all.  This in part is why the fed raising rates has had very little effect until now because finding funding isn't most banks problem, if anything, they have more interest bearing deposits than they'd like.As you point out, nobody is going to sell long bonds to jump into a gubbermint MM because we could be back to nirp faster than you can say zirpedee do dah.  however, they sure the fuck will jump out of a passbook savings account into a gubbermint guaranteed MM account that pays nearly the same rate as the fed's overnight.  combine this with the other dizzying factors expounded upon in the article and it is easy to see why this is happening.  just because most zhers think that clownbux owners are stupid, they aren't that kind of stupid.

In reply to by Gulfcoastcommentary

buzzsaw99 Wed, 12/27/2017 - 14:55 Permalink buyers of US Treasurys suddenly require far greater yields to offset the surge in funding costs!perverse, and should not exist in the first place.

DavidFL Wed, 12/27/2017 - 15:01 Permalink

Eurodollar short squeeze - here we come. I would not be surprised if in 6 mos the dollar is running thru 105. Sound collision alarm - brace for emerging market calamity.

JBPeebles Wed, 12/27/2017 - 15:04 Permalink

Article focuses on the specter of the liquidity trap. Adding too much debt results in the over-issuance of Treasuries. They fall in value. This effect is compounded by the repatriation of retained earnings held overseas.Can't get to a credit neutral situation when every potential creditor knows the state of your finances. The Budget Bill is signaling in big bold letters that higher budget deficits are ahead. As the Treasuries are sold the supply of dollars will disappear abroad. You could have read about that phenomena here at ZH if you'd been following the Eurodollar market.We knew this would happen so this didn't surprise us. The idea that a huge deficit-financed tax bill wouldn't screw with Treasury yields is absurd. The sale of bonds was both fully anticipated and anticipate-able due to the fiscal madness. Irresponsibility with borrowing always leads to higher rates--this is what the liquidity trap tells us. Emerging out of a period of easy credit is the moose exiting the geyser--like you see in Yellowstone--where it often freezes sometimes still on its feet.So the moose is trying to get out of the hot water! And the credit conditions are the wind howling and sub-zero temperatures that threaten to freeze every exposed inch of its wet fur.The credit won't be there if the dollars all come home to roost. They'll increase the rate of inflation--the howling wind--as Fed policy leaves the warm water of contentment that has fuelded this long-running Bull. Bail out of those derivative-based intangibles. Sure you might come across a correlation in your analysis that offers an opportunity but in the case of this budget bill, political and fiscal realities trump the value of quantitative analysis. Alpha comes from knowing when to not trust the machines and numbers and exert defensive precautions by not associating or assuming any sort of financial relationship between two objects, much less in an environment of rapid geopolitical change and high political risk. Counterparty risk is too high with the Aspens all connected at the roots--presuming that the market is TBTF in a cheap money environment is upping market risk and the level of interdependency within the bubble.Don't lose sight of the forest here. See the derivative-based swamp for what it is--an inadequately capitalized speculative bubble that's starved itself of the ability to borrow cheaply and now faces huge sums of money coming back into the nation--a form of push inflation not being counted like the pull kind. And even if you buy into their inflation numbers--despite the enormous self-interest associated with politicians goalseeking the numbers--they aren't the kind of infllation that's tracked by how much Americans spend but rather how large the size of the montary pool is and will continue to get. The starting minimum for money overcreation is whatever dollars need to be borrowed for government spending. This comes back but the dollars have to come from somewhere and the Fed appears to be talking normalization.

hooligan2009 JBPeebles Wed, 12/27/2017 - 16:15 Permalink

debt to gdp at start of obama era = 60% = 12 trilliondebt to gdp at end of obama era = 100% = 20 trillionfed balance sheet at start of obama era = zerofed balance sheet at end of obama era = 4 debt increased by 33% net of monetization (net 4 trillion increase from 12 to 26 trillion)ten year bond yield at start of obama era = 5%ten year bond yield at end of obama era = 2%that's some slippery moose right there.

In reply to by JBPeebles

Vilfredo Pareto TimmyM Wed, 12/27/2017 - 16:43 Permalink

I think you nailed it.   This actually gives us room to lower rates and QE, I mean monetize, more debt at the expense of the rest of the world which now is suddenly going to experience a shortage of dollars.   It can be done with no or little inflation too.   Ahhh....the exorbitant privilege.  I hope we have a fed head who will seize the opportunity

In reply to by TimmyM

Disgruntled Goat Wed, 12/27/2017 - 15:30 Permalink

So it means there is a move towards normalization of deposit interest rates for Americans ... well boo hoo .... The Fed has distorted all interest rates for a decade in favor of large financial institutions, and now we get a slight move back and the banks get their panties twisted. Tough shit. Suck it!

hooligan2009 Wed, 12/27/2017 - 15:54 Permalink

the ECB, SNB and BoJ are leading the "race to debase" their currencies in order import inflation and stimulate activity.a left field prediction for 2018 is that they will succeed, especially now that the oozing taint of quantitative easing via global linkages has ceased and only the BoJ and ECB are polluting the pool of global liquiity with their fiat - what was once "everybody print" is now "ECB and BoJ print" because the US and the UK stopped printing a few years ago.The Fed is raising rates and the soft cock libtard Carney has taken back the 1/4 pt rate cut that encouraged the run on sterling.Year end dollar per euro = parity.Year end yen per dollar = 150.Why anyone should get a hedged yield pick up into treasuries is beyond me, when JGB/GDP is 250% and the Euro is about to become the most loathed currency in the world as it morphs into a proxy for the Saudi riyal, the Czech Republic, Hungary and Poland invoke Article 7, Italy goes MAIA and Spain breaks into bits. Watch for more headlines about Target II being exposed as a fiat sponsored export credit gaurantee by the ECB for trade imbalances between northern and southern europe.anyone wanting to speculate on price action in treasuries can already use futures (plus options/synthetics) with no currency risk, so the argument in the article is based on yield alone. good luck with that when all bond markets are ten years duration times at least 2% in financially/CB repressed yields = 20% in price (50 basis points matters little when you lose 20% by chasing it).

Money_for_Nothing Wed, 12/27/2017 - 15:59 Permalink

More is going on than this article is articulating. Inflation is necessary. How else to get rid of all this debt? Don't worry. All the Fed banks are stuffed full of reserves that the Fed is paying interest on. Plan is on schedule.