The US Federal Reserve (Fed) maintained policy rates in its September meeting, but the new Dot Plot projections predict rates to be higher for longer.
Meanwhile, credit spreads tightened slightly and money market fund (MMF) assets under management (AuM) soared to a 25-year high.
September may have unveiled the last of some central bank policy rate hikes and may be the beginning of the pause we have long anticipated— the inflection point central bankers have long been hoping for. Unfortunately, inflation has not played nice and rates may be higher for longer.
The US Federal Reserve (Fed) did not disappoint with its hawkish pause. Markets had priced for no hike and the Fed did not want to disappoint. But the revision in the Statement of Economic Projections’ (SEP) Dot Plot proved to be the story.
The updated estimates had the median dot predicting just 50 bp of easing in 2024, down from the previous 100 bp of easing. The dot dispersion remains wide—as high as 6.125% and as low as 4.375%—in 2024 and wider in 2025 (as high as 5.625% and as low as 2.625%), reflecting the considerable uncertainty around inflation expectations, growth and employment.
Markets took the news in their stride. T-Bill yields reacted little, and 2-year Treasury yields, even though they spiked higher initially, have settled to be only 4 bp higher (as of 25 September 2023).
Credit spreads continue to hold well. The Bloomberg US Credit Index has tightened further on the heels of the meeting and now stands at 107 bp above comparable US Treasury debt (as of 25 September 2023).
We recently wrote about the decline in gross debt issuance since 2020. Certainly, nominal yields being higher by ~4% has an impact on corporate borrowing cost! 2023 should see another decrease in gross borrowing and perhaps this lower issuance (supply) is somewhat responsible for the tighter credit spreads. The refinancing wave should begin in 2025 and continue well into 2026, perhaps giving those who need to refinance time and hope for lower rates.
The US Treasury continues to ramp up its borrowing. Since the Debt Ceiling limit was resolved in June, the US Treasury has issued over USD 1 trn in new T-Bill debt.
All T-bill auction sizes have increased. The US Treasury has also been rebuilding the balance in its checking account (Treasury General Account, TGA). This is its account that pays all the government’s bills. That balance has increased by over USD 660 bn, from a low of USD 22 bn on 1 June to USD 682 bn on 21 September 2023. This growth is a direct drain on liquidity—the money leaves the system and sits in the TGA at the Fed.
The Fed’s quantitative tightening (QT) program also continues to drain money from the system as the Fed lets up to USD 95 bn of assets to roll off its balance sheet each month.
As US Treasury or mortgage-backed security (MBS) debt matures, it is reissued, and the new buyers must emerge. Last summer, the Fed’s System Open Market Account (SOMA) portfolio had as much as 36% of all Treasury debt outstanding. That is now 29%—a decline of almost USD 1 trn.
We have also begun to watch Money Supply (M2). A favorite indicator of the 1970s, it is back in fashion and is deeply negative. The meteoric growth in the supply of money in 2020 was the result of the unprecedented fiscal and monetary stimulus. That has changed, rather dramatically, and now is negative on a year-on-year (YoY) basis.
Due to many of the factors above, T-Bills yields have risen on a relative value basis vs. the Secured Overnight Financing Rate (SOFR) curve. 3-month T-Bills had been deeply negative prior to April 2023. Since April, they have been, on an average, 6 bp above the 3M SOFR. We can now see some of the direct effects of the liquidity drain.
With this cheapening, cash strategies are buying T-Bills and extending durations. The breakeven has been working. The extreme caution taken by MMFs in 2022—letting durations (weighted average maturity, WAM) roll into the single digits—has passed and MMF durations are now in the mid ’20s WAM. It is not exactly a dramatic extension in duration, but funds are no longer in fear of the next 75 bp hike from Chair Jerome Powell. MMFs have been taking money out of the Fed’s Reverse Repurchase Program (RRP) and buying T-Bills. The RRP is down USD 700 bn from the high balances it held back in spring. The decline has been consistent with the Debt Ceiling resolution and the dramatic increase in T-Bill issuance.
There has been some concern over this decline in RRP utilization. Ironically, there was concern over the increase in program utilization back in the spring of 2021 when the program’s balance went from zero to over a billion in a matter of months. Ultimately, the Fed would like to see the RRP balance at zero. That would indicate a healthy balance of liquidity and functioning money markets. It is probably going to be a while and several billion more of QT before we get there.
An additional effect of QT has been the increased funding needs of primary dealers. These dealers are required to bid on all of the US Treasury auctions.
When they buy US Treasuries at auction, they do not necessarily have the money to pay for them; thus, they need financing. MMFs and other short-term cash investors can provide this financing through a repo transaction, where money is loaned and US Treasuries are received as collateral.
Overall, total dealer repo balances as reported by the Fed have been trending higher for the past several months (at August month-end, there was a drop of ~USD 150 bn, but previous months’ balances were hovering around USD 3.2 trn).
The data series is volatile, though, compared to historical levels, repo balances have been heightened since the middle of 2022.
Maybe, as QT continues, dealers will be asked to finance more of the debt rolling off the Fed’s balance sheet. This should put upward pressure on SOFR rates as that financing comes more in demand and reliance on the RRP decreases further. If liquidity continues to drain, we could see the opposite of what has existed for the past two years: upward funding pressure.
But that dynamic appears to be some ways off. Investment Company Institute (ICI) reports MMF balances at historic highs. Current MMF AuM is over USD 5.6 trn. A year ago, balances were at USD 4.5 trn, and 5 years ago they were at USD 2.8 trn.
Back in 2006 and 2007, we saw similar percentage increases in cash balances. Could this foreshadow a turn in the business cycle?
Our long-term fair value lens indicates that rates (yields) are cheap and credit spreads (yield over comparable Treasuries) are rich. This divergence in pricing is like the stretching of a rubber band, and if history is a guide, it is quite stretched and unsustainable.
If our analysis is correct, then the growth rate of the US economy is likely to remain historically low and inflation moderately higher than what was witnessed post the Global Financial Crisis. This should give the Fed some room to ease off on policy rates.
But the question remains: how long is “higher for longer?”
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