by Chris Black
Inventory Costs
Treasury yields may resume their upward trend as the repricing of Fed policy expectations is likely over and swap spreads continue to widen from on-going issuance.
Treasury yields can be thought of as determined by the market’s expectation of the path of Fed policy and an extra “premium” to entice investors.
Steady progress towards disinflation has recently led a downward repricing in rates as the market both moved up its expectation of Fed rate cuts and significantly lowered its medium term rate expectations.
At the same time, swap spreads suggest that the market is increasing the amount of premium required to hold Treasury securities.
This post reviews these opposing moves suggests that a widening premium will be the stronger effect going forward (https://t.me/DissidentThoughts/2742), and notes that a Fed cut could help reduce the premium .
“Fed Pivot”
Yields across the curve declined aggressively in recent weeks as the market significantly pulled forward potential Fed rate cuts and priced in a lower longer term path of policy.
As noted on November 1, the market had been pricing in a path of policy that was too restrictive given progress on inflation and rising longer dated yields.
The rate of inflation has steadily declined to below 4%, with the most recent CPI printing at a 0% month over month basis.
At the very least, this merits a few cuts to keep real rates steady and maintain the current stance of policy.
This realization has led to market to increase the chance of a cut in March from 0% last month to around 30% today.
Market pricing of longer term Fed policy is unlikely to decline further, which reduces the likelihood of further declines in longer dated Treasury yields.
SOFR swaps at longer dated tenors have declined by around 40bps the past month.
SOFR swaps show the market’s expectation of Fed policy over a set term, e.g. a 10 year swap rate of 4% indicates an overnight Fed policy rate that roughly averages 4% the next 10 years.
The recent decline in 10 year Treasury yields is largely due to this repricing. The shift is not unreasonable given apparent stickiness of inflation around 3.5%, but it does suggest that further declines in policy expectations is unlikely. A number of factors suggest longer term inflation could stabilize above 3%, including demographics ), friend shoring (https://www.bloomberg.com/news/articles/2023-09-11/-friend-shoring-is-a-us-trade-policy-that-s-good-news-for-india-vietnam), unsustainable fiscal spending (https://www.fiscal.treasury.gov/reports-statements/financial-report/2021/unsustainable-fiscal-path.html) and a potential change in the inflation target (https://www.wsj.com/articles/the-fed-should-carefully-aim-for-a-higher-inflation-target-reserve-powell-greenspan-5fef5051).
Capacity Limits
The premium required by market participants to hold Treasuries has been steadily increasing with net issuance.
One measure of premium are SOFR (https://www.newyorkfed.org/markets/reference-rates/sofr) swap spreads, which are the difference between the swap rate and Treasury yield of the same tenor. In theory, negative SOFR swap spreads (yields higher than swap rate) is a free lunch as an investor could buy a Treasury, fund in overnight repo, and hedge out the repo interest rate risk with a swap.
But in practice the trade incurs regulatory costs under the post-GFC regulatory regime. Recall, dealers incur regulatory costs based on the size (https://fedguy.com/to-slr-or-not-to-slr/) and composition (https://fedguy.com/slr-sets-size-but-lcr-shapes-composition/) of their balance sheet.
Dealers holding Treasuries funded in repo or providing repo financing to leveraged investors recoup those costs by widening the spread.
Note that these regulatory costs are also why the FX swap basis structurally widened post-GFC (https://bfi.uchicago.edu/wp-content/uploads/2021/05/BFI_WP_2021-57.pdf).
The recent widening of swap spreads suggest dealers are at capacity and demanding higher compensation for their balance sheet.
The marginal buyer in cash Treasuries has been leveraged investors, who require dealer repo financing. Moderating growth in repo lending after an early year surge suggest that dealers have approached capacity in providing repo loans .
Dealers have also increased their own Treasury holdings, which takes up balance sheet. At the same time, Treasury issuance sizes continue to increase) and are then expected to stabilize at a historically high level .
The widening swap spreads in effect means that dealers are charging more for their balance sheet, whether it be to hold Treasuries or provide repo financing.
This puts upward pressure on yields and is likely to continue until demand picks up from cash investors, who buy Treasuries without dealer repo financing. This itself is unlikely however.
Generating Demand
A potential March rate cut would steepen the curve and thus create demand for cash investors that could narrow swap spreads.
Research suggests (https://libertystreeteconomics.newyorkfed.org/2023/02/understanding-the-inconvenience-of-u-s-treasury-bonds/) that a flat or inverted yield curve leads to reduced demand for Treasuries, which then ends up as inventory on the balance sheet of primary dealers.
A cursory glance of historic data shows that primary dealer net Treasury holdings tend to rise as the curve inverts.
This could be due to real money investors preferring to hold higher yielding Treasury bills, foreign investors discouraged by high FX hedging costs, or leveraged investors unwilling to accept negative carry. The curve is currently inverted and may not be positive sloping until after two Fed cuts.
With the path of policy largely in line with progress on inflation, longer dated yields can resume their march higher due to widening swap spreads.
There will be volatility, but until the Fed actually cuts rates the near term trend in yields is still higher.