Federal Deficit and Markets
David R. Kotok, Chairman
Cumberland Advisors, May 5, 2013
Jim Bianco noted an interesting development in his May 1, 2013, chart pack. He observed that in the second quarter of this year the US Treasury was paying down debt for the first time since 2006.
We started to think about that and what the implications might be for Treasury bond pricing in the present market environment. We have not seen this type of Treasury paydown since 2Q 2009.
We still have the Federal Reserve (Fed) spending $85 billion a month to purchase Treasuries and federally backed mortgage paper. That differentiates the present period from 2009 and earlier eras. Part of that purchase is to replace maturities that roll off. A second part is newly printed money in the form of QE applied toward absorption of federally guaranteed bonds and notes.
Meanwhile, we are now in a quarter in which the US Treasury is decreasing its outstanding debt. So, if you include the Fed with the Treasury as combined arms of the federal government, the federal debt in the hands of the public will actually shrink this quarter.
Remember that the Fed, along with other major central banks, was on the sidelines the last time we had any period of paydowns. We wonder whether this development marks a regime change, a paradigm shift that helps explain why Treasury yields in the intermediate term (10-year note) are so low. Do the paydowns add to the downward momentum of yields?
Let’s go a step farther. Bianco points to Treasury officials’ projections for borrowing in 3Q 2013. They estimate that borrowing at $223 billion. That number is much lower than its counterpart in any of the years since the financial crisis triggered the new Fed QE policy. If we assume that the Fed continues its present $85 billion a month QE policy in 3Q, we can argue that the combined actions of the Fed and the Treasury will mean no net impact on the publicly held Treasury supply. Half a year will go by without any net new Treasury debt being placed in the market.
New debt issuance since the financial crisis has been lower than in prior comparative periods. In the combined third-quarter projection and second-quarter realization, we see, as a result of declining net issuance of federal debt with market pressures reduced by hundreds of billions of dollars. At the same time, Fannie Mae and Freddie Mac are still embroiled in their restructuring debate, and their issuance, too, is much less robust than it was prior to the financial crisis.
Where are we going with this thought? Well, it appears that, while the Fed continues to absorb new issuance of federally backed securities, the amount of new issuance is declining on a net basis. That helps explain lower interest rates. Simply put, the price goes up when you have less of something produced and more of it purchased. When it comes to bonds, that means that yields go down.
We note the same activity underway in the rest of the developed world. We see it in the Eurozone, where it is increasing. We see it in Japan in the form of a policy change of monumental proportions. We also see it in the UK and in other G20 countries.
All this leads us to the following place. As long as these central banks continue with QE and their short-term interest rates are held near zero, the likelihood of decreasing interest rates is much higher than market expectations may reveal. And the likelihood of abruptly rising interest rates is further reduced as long as the central banks collectively are involved in quantitative easing.
The outlook is for at least another year or two at the current momentum. No central banks are involved in cessation of easing and extraction of excess reserves they have created. Most are still expanding. Discussions of “tapering” are commencing. Tapering means slowing the pace of expansion of reserves. Once tapering is underway, there has to be stabilization and then a gradual period of reduction. The studies we have seen indicate that this process will take many years.
No central bank wants to shock the economy the way the Fed did in the late 1930s, with its too-soon response. Chairman Bernanke, Vice Chairman Yellen, and their colleagues in the Fed’s governance structure are very familiar with Fed history and the mistake made in the 1930s. They have written about it and referred to it.
That experience suggests that they will err in the direction of waiting too long before removing QE or tapering the existing process. They will not be symmetrical in the decision-making process between too soon and too late: too late wins this argument. For investors, that means a prolonged period of very low interest rates, which are bullish for asset classes of nearly all types.
Cumberland’s accounts remain fully invested in US stocks. Our international accounts are fully deployed. Our bond accounts continue to hold longer-duration instruments. We are gradually introducing and developing interest-rate hedging structures in preparation for an eventual rise in interest rates.
In a coming essay, my colleague, Bob Eisenbeis, will discuss what this means for collateral scarcity.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors.