Is the DM Rates Rally Due a Reversal?

We believe the developed markets (‘DM’) rates rally from end May/early June – that was the main driver of risk assets performance – is likely to be reversed for three main reasons.

First, the monetary expansionary effect of the USD213 billion drop in the US Treasury’s cash cushion (declining from USD400 billion at the beginning of May to USD188 billion to June 12)¹ was equivalent to an annualised quantitative easing of USD1.8trillion. This is very close to the levels experienced at the peak of QE in 2017 (Figure 1) and impacted the US yield curve accordingly (on the short end, by the injection of liquidity, and in the long end, by the lower issuance of US Treasury debt).

This impact should reverse once a new debt ceiling is negotiated and the Treasury is able to resume its borrowing plans.² In light of the pace that the Treasury is spending its cash cushion, we anticipate that such an agreement needs to be reached before the end of summer. This will work as concentrated quantitative tightening on a short period of time, as the Federal Reserve will have to, in our view, replenish its cash base and fund its larger deficit. The impact in the yield curve and risk assets is likely to be exacerbated by the current long positioning and tight valuations across the board.

Transversal to the US Treasury cash cushion changes, a larger US deficit will lead the net new supply of Treasury debt to increase from USD500 billion annually until 2017 to roughly USD1.1 trillion from 2018 on. This is equivalent to a cUSD600 billion increase in annual US Treasury bonds supply that will, we believe, accumulate annually over the years and will crowd out demand for substitute assets, emerging markets (EM) included.

Secondly, in the US, core CPI and core PCE have shown weakness on the inflation front, but alternative measures to core inflation have been pointing to acceleration. The Fed chairman and the vice-chairman have been very vocal in pointing to transitory factors being the main drivers of this weakness, namely the change in the way the Fed collects the data. We expect firmer inflation to reassert itself over the medium term as labour conditions continue to tighten. A strong dollar will serve as a deflationary downdraft. However, this should be partially offset by the impact of higher tariffs on end prices as US retailers and Chinese manufactures may not be able to absorb the latest round of tariffs on Chinese goods.

Figure 1. Treasury Deposits at the Fed and Treasury Yields

Source: Bloomberg; as of June 11, 2019.

Currently, the market is already pricing a very aggressive policy response, including up to three to four rate cuts this year alone. However, the inflationary effect mentioned will make it harder for the Fed to surprise to the dovish side given the magnitude of cuts being priced by the market, thereby reducing the magnitude and time period that risk assets will trade positively in reaction to that event.

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Source: Bloomberg; as of June 4, 2019.

Third, the European Central Bank on June 18 notched up its dovish tone. ECB President Mario Draghi hinted that the Governing Council may be willing to tolerate inflation running above the ECB's goal to compensate for the recent, protracted period of below-target price gains. Such a strategy would involve more monetary stimulus in the form of further interest rate cuts (from the current negative level of -0.4%) or restarting the asset purchase program (QE). The new bias seems to rule out any monetary tightening for the foreseeable future.

Our issue with the ECB announcement is that we doubt it will be able to perform QE in the magnitude required to trigger another sustainable risk asset rally such as the one we saw in EM in 2017 and early 2018. When QE peaked in 2017, the balance sheet of the G3 central banks expanded by USD2 trillion annualised (Figures 3, 4). To get back to that level of global stimulus, we believe the ECB would have to inject liquidity well beyond the level it did back then, as it will need to offset the impact of the incremental USD600 billion annualized US Treasury debt issuance, and the absence of QE by the Fed and the Bank of Japan.

Moreover, Draghi is leaving the ECB in four months, and when European authorities are not even able to agree in the name and/or nationality of the successor, it appears unlikely, in our view, that we would get QE in magnitudes even remotely near what we indicated earlier.

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Source: Bloomberg; as of May 31, 2019, projections through December 31, 2019.

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Source: Bloomberg; as of May 31, 2019, projections through December 31, 2019.

If we are wrong about this, we still think that the rollover of the debt ceiling and the liquidity drain that it would trigger would give us an opportunity to turn the portfolio around. Meanwhile, we will continue to monitor what concrete measures the ECB and other central banks implement.

 

 

1. FARBDTRS Index: US Factors Absorbing Reserve Funds Treasury General Account Deposits. Source: Federal Reserve.
2. The debt ceiling limit was reinstated on March 2 after being suspended by a year. So far, the Treasury Department has been shifting funds and taking other extraordinary measures to prevent a default on the government’s debt. Without an increase or suspension of the current debt ceiling, the US would be heading for a default by late summer (according to the US Treasury secretary) or by end 2019 (according to the view of Congressional Budget Office). The government is in talks with Congress on raising the debt ceiling and lifting spending caps.