WHAT DO CREDIT MARKETS SMELL?

CREDIT LEADS STOCKS

Financial repression continues to keep spreads low (excluding China). However we note the relative under-performance of High Yield (HY) bonds vs Investment Grade (IG) bonds in the chart below.

This is a classic warning for stocks since we have found it to be a reliable leading indicator for stock pricing.

FED BALANCE SHEET GROWTH BEGINNING TO FLATTEN

The chart below is operating with a reporting delay but nevertheless still shows a flattening growth rate on the Federal Reserves Balance sheet. This is being caused by three drivers or potential drivers which we will discuss next.

1- REVERSE REPOS REDUCING TOTAL BANK DEPOSITS

O/N RRP APPROACHING $1.2T

The Federal Reserve is [umping cash into the market through its current bond buying program at the rate of $120B/ Month via $80B of purchases of US Treasuries and $40B of Mortgage Backed Securities. This increases bank reserves to buy US Treasuries by (12 X $80B) $960/Year.

However, at the same time the Fed is pulling out cash reserves of a rate just shy of $1.2T in overnight Reverse Repo operations.

This computes to a draw-down rate of Total Bank Reserves of $240B or nearly $1/4T of liquidity per annum. This is small but nevertheless a draw-down.

There are four drivers that create a contraction:

1. Repayment within Discount Operations window (this seems remote),

2. Currency in Circulation is increased. This is likely but not a major concern as shown by the green line but not seen as a major concern – at least yet,

3. Treasury Deposits at the Fed increase – this is also not a major concern,

4. Reverse Repo levels increase. This is a major concern since they have already spiked to $1T and many are calling for a doubling from this level!

ADDITIONALLY:

·Bank Reserve Liquidity will fall if QE Tapering were to begin

·Overall market Liquidity will fall if the Treasury’s Debt Ceiling is not suspended again because Treasury Spending will be crimped.

·Bank Reserve Balances will not grow if ongoing Treasury Supply is not issued or rolled over.

2- INCREASING TREASURY SUPPLY

When the US Treasury issues more supply than spending, it is a stealth form of “Quantitative Tightening”

The US Treasury has trapped itself into being forced to unleash a massive Quantitative Tightening in the coming months which will drain a further $500 billion in liquidity by year-end.

The combination with the build in Reverse Repos (assuming it increases to a project ~$2.0T level with no ending of QE) amounts to ($800 + $500) $1.3T.

This will be higher if:

• US Treasury is forced to draw down the TGF to $0 from $300B due to delays in approval to defer the Debt Ceiling which could take the QT to $1.5T,
• Any amount of ‘Taper’ is implemented before year end,
• If the O/N RRP is forced above the currently projected #2.0T daily level.

The Man Group reports:

In a ‘normal’ world (where the debt ceiling isn’t an issue), the US Treasury would not have tapped into its cash balance. Instead, it would have issued enough debt to match its spending needs. Net net, this would have no impact on markets – the amount the Treasury spends (which is like a cash injection into the US economy) would be offset by the amount of debt issuance (this would take liquidity out of the system as investors would be using their cash to buy US Treasury instruments).

However, in the last few months, the US Treasury has slowed down issuance because of the debt ceiling. This, in turn, has forced the Treasury to tap into their ‘rainy day’ fund and deplete its cash balance. Because it hasn’t done much issuance to take out liquidity, net net, these actions by the US Treasury have acted like substantial quantitative easing (i.e., cash injection without the offsetting liquidity withdrawal from issuance).

Separately, the Treasury has indicated that once the debt ceiling is increased, it plans to run the cash balance at USD750 billion. This would imply that the Treasury is taking more out of the system via issuance than it is putting back into the system via spending, because it is replenishing its rainy-day fund. This acts like quantitative tightening..

3- TAPER TALK MAKING BUYERS HESITANT

The Fed is in the process of preparing the market for a tapering decision in the near future. The question is no longer whether we will see tapering or not, but more about the timing, the length of tapering and not least the market impact of tapering.

The consensus of analysts is they do not expect a firm tapering announcement before the September FOMC. Many now expect that tapering will be concluded by summer 2022 followed by a rate hike late in 2022.

Although a tapering announcement this autumn should be no major surprise to the market, many argue that the recent curve flattening is too early in the cycle. We still have a bond market that has to adapt to significantly lower QE purchases in 2022 and the first rate hike is also moving closer in time. Hence it is likely we will see some upside for US yields in Q4 and in 2022.

We might also assume that a further improvement in the US labor market and a repricing of the current very low real rates will add upside to US 10Y yields.

CONCLUSION

Unexpected problems associated with the exploding size of o/n Reverse Repo operations in the short term funding market, along with US Treasury General Account due to the expiration on July 31st of the Debt Ceiling moratorium and expected Fed Tapering are forcing

STEALTH QUANTITATIVE TIGHTENING

If private sector market participants still have any ability to anticipate future developments, then we are likely near the point where investors begin to reduce their rates positions to make room for the increased issuance that would take place the moment the debt ceiling rollover happens. In due time, this should have an impact on asset prices that depend on long-term yields.

Man Group