Reversal of flows
May 23, 2021
Major flows could reverse by summer
The week ended with both three month libor and the Bloomberg bank funding index (BSBY3m) at new record lows, 14.700 bps and 11.578 bps. The front June Eurodollar future ended the week at 99.8525 or 14.75 bps. At the same time, July ten year treasury implied vol went just under 4%, the lowest level since late February, while the ten year yield hovers around 1.63%, down just one bp on the week. China’s ten-year yield ended at 3.07%, the lowest since September of last year. At 6.4342, the yuan is near the strongest level of the year versus USD.
In terms of inflationary pressure, contrast the yields noted above with these comments from a conference call with Cummins, Inc. “You name it, and we have a shortage on it,” Tom Linebarger, chairman and CEO of engine and generator manufacturer Cummins said on a call this month. Clients are “trying to get everything they can because they see high demand,” Jennifer Rumsey, the company’s president said. “They think it’s going to extend into next year.”
For anyone who thinks it’s all going to end in a few months, consider the somewhat obscure U.S. economic indicator known as the Logistics Managers’ Index. The gauge is built on a monthly survey of corporate supply chiefs that asks where they see inventory, transportation and warehouse expenses — the three key components of managing supply chains — now and in 12 months. The current index is at its second-highest level in records dating to 2016, and the future gauge shows little respite a year from now. The index has proven unnervingly accurate in the past, matching up with actual costs about 90% of the time.
In my view, the increased inflation outlook is becoming entrenched, in part because of pent-up demand, in part because lack of previous investment in productive supply (which is going to take a while to catch up), and finally, because the dollar continues to trade weak.
The big story of the week concerns the Fed’s massive Reverse Repo operations which totaled $369 billion on Friday. Obviously there are huge excess reserves looking for some sort of yield. As the government draws down balances in the Treasury General Account (TGA), these excess reserves grow. A good and succinct explanation of the mechanics is contained in this link:
https://fed.tips/sico4-1/
Here are a couple of excerpts:
One may ask here why would Fidelity choose to use the Fed RRP, which is paying 0bps? Why can’t Fidelity invest in T-bills instead for higher yield? Of course, Fidelity would buy T-bills instead, if there were T-bills yielding better than 0bps available in the market. And it was indeed the case before Q2 2021. However, since the beginning of April 2021, in each week, Treasury has been letting ~$39Bn worth of T-bills (specifically, cash management bills) to mature to lower the TGA balance. T-bill has been scarce, in comparison to the large deposit balances MMFs are carrying, as a result of QE (which removes UST from the market) and Treasury’s effort of replacing T-bills with longer duration T-notes and T-bonds. Fed RRP is now the highest yielding vehicle for many MMFs, and that’s why RRP balance has been edging up every week lately.
That said, for us traders, let’s enjoy this new trading regime in which the price action in equity market is closely driven by the Fed/Treasury/GSE cash flow and the reactive MMF flow (rising RRP is bullish for stocks because it lowers banks reserve footprint, vacating precious balance sheet space for total-return swaps and other derivatives that enable leveraged speculative positions). This regime should last at least into the next Fed meeting (June 15-16th).
The technical factors associated with the Fed’s plumbing are causing pressure on all short term rates.
At the same time, that’s a likely partial explanation for pressure on implied vol in treasuries. We’re just over three weeks away from the next FOMC, where the Fed will have to tweak IOER to alleviate this situation. In the meantime the pressure on short term yields spills over into longer maturities as well. Simultaneously, China has cracked down on crypto and is trying to tamp down on commodity prices.
The broad overarching situation is that inflation appears to be taking hold for what might be less of a transitory period than the Fed currently thinks. Policies of continued QE seem to be exacerbating the situation by adding to reserves, while the gov’t draws down TGA balances which are being used for transfer payments, thus disincentivizing labor. The next few Fed meetings are June 16, July 28 and September 22. The Fed’s Jackson Hole symposium is typically around the last weekend in August; this year it should be August 26th to 28th. September treasury options expire on August 27, coinciding with Jackson Hole. For that reason, implied vol on Sept trades at a significant premium to July.
The next several Fed meetings may be extremely important. What is more transitory than inflation is the amount of time that the Fed will be able to hold current policies in place. Communication to jawbone down inflation may not be enough, especially if there’s a nice bounce in the next employment data. In a recent talk at the USC Marshall School of Business, Stanley Druckenmiller said, “Simply put, the fastest and strongest recovery from any post-war recession is being met by the easiest response on record by the Federal Reserve, by a mile.” He adds, “I believe we have crossed the Rubicon” and says he thinks the US dollar will lose reserve currency status within fifteen years. Interestingly, he said that the dollar didn’t decline during the covid period, even as foreigners were net sellers of US bonds, because large US companies that were perfectly positioned for the digital economy drew huge foreign investment, thus counteracting bond sales. If that thesis is correct, then the dollar may be ready for another large leg lower. In short, recent major flows with respect to the dollar and excess reserves may run their course by the official start of summer. Yields will revert higher and risk assets could see pressure as USD makes new lows for the year.
| 5/14/2021 | 5/21/2021 | chg | ||
| UST 2Y | 14.9 | 15.5 | 0.6 | w/I 16.2 |
| UST 5Y | 81.9 | 82.6 | 0.7 | w/I 84.7 |
| UST 10Y | 163.7 | 162.8 | -0.9 | |
| UST 30Y | 235.4 | 233.1 | -2.3 | |
| GERM 2Y | -65.6 | -65.4 | 0.2 | |
| GERM 10Y | -12.9 | -13.0 | -0.1 | |
| JPN 30Y | 65.2 | 67.1 | 1.9 | |
| CHINA 10Y | 313.6 | 307.1 | -6.5 | |
| EURO$ U1/U2 | 13.5 | 14.0 | 0.5 | |
| EURO$ U2/U3 | 53.5 | 54.5 | 1.0 | |
| EURO$ U3/U4 | 61.5 | 63.5 | 2.0 | |
| EUR | 121.47 | 121.81 | 0.34 | |
| CRUDE (active) | 65.36 | 63.58 | -1.78 | |
| SPX | 4173.85 | 4155.86 | -17.99 | -0.4% |
| VIX | 18.81 | 20.15 | 1.34 | |
https://www.ttnews.com/articles/world-economy-suddenly-running-low-everything
