When is a market not a market?
A market is not a market once it has been cornered.
There is growing concern about where rates are headed. That is normal. There is growing concern with the seemingly bizarre trading of the longer end of the curve. That concern is normal too. What isn’t normal is the nature of the bond market today and that goes a long way to explaining what we are currently seeing.
Let’s focus on the 10 to 20 year part of the curve for example. There will be no new issuance in that part of the curve if we count new 10 year bonds as part of the 5 to 10 year bucket. All we get is some small amount of roll down which doesn’t change the argument much.
Of the $221 billion of bonds in that 10 to 20 year bucket, the Fed already owns $93 billion, or 42%. Since the Fed is limited to no more than 70% of any one issue, they could buy up to their max position of $155 billion in under 2 months of QE. If the Fed decided they wanted to push aggressively on the 10 to 20 year part of the curve, they could own 70% of it by the end of March. Is there any reason to assume the Fed wouldn’t do this? Seriously, think about it. This Fed is aggressively trying to manipulate rates both across the curve and across products. They may well do things we never dreamed possible if it suits their policy agenda.
Of the remaining 30% of bonds, how many are held in not available for sale accounts? Some portion of the longer dated bond market is held by entities that aren’t actively willing or even able to trade it. The potential free float is tiny. The existing free float may already be small.
When we look at the 20 to 30 year (or what has become TLT land for retail) we see a similar story. The Fed already controls 37% of the market and could buy up to 70% in less than 7 months even if we issue some new long bonds. Again, what portion of the long bond market is held by investors who aren’t the selling type?
We talk about the size of the treasury market, and with T-bills, Bonds, and TIPS, it is over $11 trillion (I didn’t include the $800 billion of TIPS because they would have required me to build a more complex spreadsheet, and don’t think it changes much of the analysis).
So we all think about this “super liquid” $10 trillion market, but where we want to place the bets, there is already a maximum of $620 billion that is free to trade (and I suspect that is highly overstated given the existence of not available for sale accounts). It is not a co-incidence that this is the case.
It isn’t “random” that 76% of the Fed holdings are longer than 5 years. It is part of a plan that the Fed now owns about 40% of all bonds longer than 5 year maturity. Nothing about the portfolio construction is random, and that is important to remember. Whatever you want to say about the Fed, they are very smart people. You can disagree with them, but they have an agenda and will execute it. They only tell us part of their agenda, the rest we have to figure out, but it is no coincidence how they built out this portfolio. They want to be able to control rates, and if you think they won’t use their ability to buy up to 70% of the longer dated market in a few months, then you are betting against what the data tells you.
The Fed can control the front end with their pledge to keep rates at 0%. So long as they keep that pledge, the front end (2 years and in remains under control). The 2 to 5 year range needs a bit of help, but greed, and otherwise steep forward curves, help the Fed in that battle. It is the longer end as well.
The Coupon Story is Useful as Well
The Treasury currently pays out $203 billion in coupon interest and something on the t-bills, which I took the liberty of rounding to 0, which isn’t that far from the truth.
What we see is that while the Fed only owns 16% of all T-bills and Bonds it controls almost 30% of all interest paid. Again, the Fed is managing this on purpose. Bonds with greater than 8% are all almost at the 70% limit. They went and targeted those bonds. It lets them funnel more money into the system by buying high-priced bonds, and has a bigger benefit to treasury who gets to pay itself the 8% coupons and leaves the rest of the world to own the 1% and 2% coupon bonds.
The Fed paid for hurricane Sandy. Hurricane Sandy will cost us $60 billion or so, and the Fed, happens to have $60 billion in income that can be used. Our deficit this past year would have been $100 billion greater without the Fed direct payments (they have mortgages and other assets).
The indirect benefits are also large. A measly 1% higher rate on the one year debt getting rolled over would have added $30 billion to the deficit. The numbers are mind-boggling. If Ben could figure out how to get himself paid 2 and 20 on that portfolio he would be one rich professor.
So what does this all mean?
I don’t see how the Fed announces anything that talks about taking down the balance sheet. Not now, and possibly not ever. The moment people get concerned, the market will start pricing in the unwind, no one will want to buy the long end of the curve and it will play havoc with rates. Who in their right mind would buy 10 year treasuries when you know that the equivalent of multiple years of supply is being sold by the Fed along with the ones the Treasury department will need to sell. It isn’t like the Treasury department will be able to stop issuing bonds. They have to deal with rolls and frankly with ongoing deficits.
As a hedge fund, are you really going to “fight the fed” and buy 10 year bonds once you think they need to sell them? I don’t think so. More importantly, who will make a nice 10 year mortgage when the 10 year treasury is selling off?
That is the problem. The Fed has built up such a large portfolio, that the only likely way to exit it is through letting it mature. That at least takes the $2 trillion seller out of the market (remember, they are still in buying mode).
Due to the potential damage a sell off occurs, both in the cost of funds for the treasury, but more importantly in the knock on effect it has on other yield products, I would expect the Fed to defend any big move aggressively. Not only do they have the money to do it, but the float is small enough it may take far less than people think to defend the market.
There is another reason the Fed will be reluctant to sell. The government needs the income. As the Fed sells, they hand back less to the treasury, so not only do we have to pay a higher rate on new borrowings, but we will be receiving less income.
Maybe this can occur in some ideal world where growth is “so good” tax receipts outpace anything else, but I think you are now requiring a fairy tale ending, rather than a mere “goldilocks” ending, let alone the disaster scenario of being forced to stop buying without real growth taking hold.
So we may “not be Japan” but we may have reasonably low rates for some time. I still have long the long bond in the “Best Ideas” and have been tempted to cut it but when I look at this along with the economic data, I think I keep it for a trade. I would like to recommend a double position in it, but am frankly scared enough that with so little liquidity we could see another big downside day and want to keep some powder dry.
Stay warm, good luck with the storm if you are affected, and put yourself in Ben’s shoes and see why you think he has created this particular portfolio and how you would react to various market moves if you were him. I suspect you will come up with the same conclusion, which is this market will be defended and is easier to defend than we have been conditioned to think.
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