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Vince Foster: The Key to Understanding What's Happening in the Bond Market


It's quite possible that bond market participants foresee two main scenarios playing out, and both are arguably bullish for bond prices.

Last year, when members of the Federal Reserve first floated the idea that they would soon begin to taper the third round of asset purchases only a few months after the program began, I explained why this policy shift may be positive for the yield curve. Most market participants were focused on the impact of the purchase flow and asset side of the Fed's balance sheet; I believed the market discount embedded in the yield curve was more focused on the reserve creation that resided on the liability side of the balance sheet. On April 15, 2013 in Contrary to Consensus: Why Tapering QE Is Bullish for Treasuries, I wrote:

In the context of how the bond market is going to react to a tapering of accommodation and the eventual exit from the easing cycle, I think we need to determine the answer to the following question: What has more influence on the yield curve, the weighted average duration of purchases or the credit created to finance those purchases?

What governed market prices was not as much about the flow of purchases but rather the credit created to finance those purchases, which manifested in the monetary inflation risk discount embedded in the historically steep yield curve. I believed that once the Fed decreased this credit creation, the reduction of accommodation would exert flattening pressure on the yield curve, which would provide support for long-term interest rates:

The consensus wants to be short the long end of the curve when the Fed tapers or exits altogether because that is where the purchases have been focused. However the yield curve is responding more to the level of accommodation, and any reduction should produce a flattening bias and a headwind for the shorts.

Since the Fed commenced tapering asset purchases, 10-year and 30-year yields have dropped by 60 and 70 basis points, respectively. This move has confounded just about everyone on Wall Street, who have produced all sorts of colorful stories about why this may be happening. These stories claim illogical and non-fundamental reasons for falling interest rates. What has become obvious is that few on Wall Street actually understand how the bond market works. There is a perfectly logical and fundamental reason interest rates are falling.

This past week, a few bond market strategists issued reports mapping how the Fed's tightening campaign might unfold. While it's a bit frightening that no one (including the Fed) really knows how the Fed is going to raise interest rates, it's likely their intent to elicit a range of ideas of how tightening might occur. It's encouraging to have different pros and cons debated among participants.

JPMorgan (NYSE:JPM) chief strategist Michael Feroli addressed "the mechanics of liquidity training" with a hypothetical of how the tightening might work. Feroli highlights the challenges and risks facing the withdrawal of liquidity (emphasis mine):

Decisions the Fed makes about its exit strategy could affect the allocation of trillions of dollars of balance sheet within the financial system. As a byproduct of its asset purchase programs, the Federal Reserve has created over $2.5 trillion of reserves -- which are a liability of the Fed but an asset of commercial banks. Now, as the Fed reviews its approach for controlling short-term interest rates, technical decisions it makes will influence whether its balance sheet will continue to be funded mostly by commercial banks, or whether money funds will take on more of the Fed's liabilities.    
This source of the Fed's liability funding source is an important distinction that is currently underestimated by participants.
There is a growing consensus that the Fed's primary tools for draining liquidity are going to be newly devised deposit facilities already in place: the term deposit facility (TDF), the reverse repo facility (RRP), and the interest paid on excess bank reserves (IOER). Commercial banks already earn interest on reserves deposited at the Fed. The newly tested TDF and RRP are available to non-bank entities -- namely, money market funds and GSEs. As Feroli notes, the TDF is a fixed-allotment amount with a market determined rate, and the RRP is a full allotment amount at a fixed Fed determined rate.
The Fed will "mop up" excess liquidity in the financial system by adjusting the rate between the three facilities. However, as Feroli notes, this process faces its own risks; he cites NY Fed President Bill Dudley's concerns over banking system intermediation:
A related concern is that growth in money fund balance sheets could lead to a sudden decline in bank balance sheets, which might have unintended consequences for credit intermediation. For example, depending on their funding profile, a sudden shortfall in reserve assets held by the banking system could lead to a scramble for other high-quality liquid assets -- potentially to the detriment of better uses for bank balance sheets.
When the Fed turns on the full-allotment RRP and TDF, it will be in direct competition with all other borrowers for short-term funds. That includes the US Treasury, banks, broker-dealers, and non-financial corporations. That is fine from a price perspective. Investors will assign relative prices for term, credit, and liquidity risk. What is different, though, is that the quantity of money that is deposited at the Fed becomes dormant. Funds that flow to other money market borrowers is money that is spent, lent, or invested for basic operating purposes. Funds deposited at the Fed will receive collateral in return that is not able to be used (rehypothecated) for other borrowing purposes.

Funds deposited at the Fed could have a material impact on the velocity of money. Thus, while the excess liquidity won't necessarily leave the system, transferring from excess reserves to reverse repos is potentially a significant tightening of financial conditions. So not only is bank credit disintermediation a risk, but also it risks the disintermediation of all financial system credit, which introduces systemic risk. I believe this is a key to understanding what's happening in the bond market.

It's quite possible bond market participants foresee two main scenarios playing out, and both are arguably bullish for bond prices: 1) that this exit process is going to take a lot longer than officials are leading us to believe and thus interest rates are lower for longer, or 2) that this exit process happens too fast and the financial system faces a severe liquidity vacuum that collapses the curve.

As participants continue to debate the exit timeline and path of rate hikes, I will take my cues from market price, which seems to know exactly where it wants to be. Consider the eurodollar curve for futures prices of 90-day Libor where the battle is being waged. If you look at the slope of the curve at three different time frames -- last Friday (5/30), six months ago (on 11/29/13), and 12 months ago (on 5/29/13) -- there has been some shifting of expectations. 

Eurodollar Curve

Last May, before the big taper blowout, the curve was notably flatter. The following November, prior to taper commencing, the curve was much steeper. Friday, the curve had re-flattened. However, you will notice that throughout this intense volatility there are two months that are relatively unchanged: September and December 2016 priced at 1.68 and 1.935 respectively. With a roughly 18bps credit risk premium for Libor over the Fed's reference rate, the eurodollar market is pricing in at 1.50% and 1.75% rate in September and December 2016.

While Fed officials continue to bark about higher interest rates, the market is telling you where it wants to be. The eurodollar market is the deepest and most liquid market in the world. There is a reason it's called the money curve. It's where US dollars are priced, and it knows how much money is needed and how much is available at that price. The Fed knows this. The bond market knows this. This is why the curve is flattening. It's completely logical and fundamental. The economy is still fragile and the system is vulnerable. There is little reason to tighten conditions very much or very fast.
Twitter: @exantefactor
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