The Fed and the Treasury: Who is boss?

Sunday, June 25, 2017 // Written by Enzio von Pfeil

We all know that the Fed is in the business of controlling its mini-rates, the Fed Funds. But with the unwinding of QE, it just could be that the Treasury has a greater role to play in this rate-hike cycle...

  1. Overshoot threat.  A couple of weeks ago, we postulated that the Fed might overshoot by raising rates too much over its next four meetings this year, thereby choking the economy in its tracks and thus causing an anticipatory stock market crash around Christmas time.  We might have to move those goal posts more towards 4Q17.
  2. Half the story.  The Fed's actions are half the story. The other half consists of the Treasury's unwinding of Quantitative Easing (QE), or: "quantitative tightening". As Jason Cummins penned in the Financial Times (FT) of 7th June 2017, p. 18: "Ultimately, the degree of (monetary) tightening will depend on choices the Treasury makes in managing its stock of outstanding debt, which is unaffected by whether the central bank is buying or not. In other words, the Fed has decided  on the impact of quantitative easing  by manipulating the term structure of the Treasury's liabilities, but the Treasury will have to decide on the impact of quantitative tightening when the Fed stops buying."
  3. Treasury-induced rate rises. Cummins notes that "When the Fed stops buying Treasuries, the debt does not disappear magically.  The Treasury Department has to find someone else to buy it...The simple economics of supply and demand tell us that increasing the supply of marketable Treasury debt means its price will fall and yields will rise. Recently, the Treasury estimated that normalization of the Fed balance sheet would cause a funding gap of about $1 trn in the coming years.. (So) the question is how much will interest rates have to rise for that much additional debt to be sold?  Consider two extremes.  Suppose the Treasury decided to raise all the additional debt (i.e. that $1 trn mentioned above: your author) using short-term securities such as T-Bills. That would put upward pressure on short-term interest rates and flatten the yield curve. Alternatively, suppose it decided to use long-term securities such as the 30-year Bond. That would cause long-term interest rates to rise and (thus) steepen the yield curve." Summa summarum, "...the Fed does not get to decide the impact of quantitative tightening. That will be the most consequential choice of Steven Mnuchin...
  4. Complicating factor: Treasury debt ceiling expiry.  All of this quantitative tightening assumes smooth sailing ahead. But squalls will occur come late summer/early fall when Congress has to go through the antics of raising the federal debt ceiling. Given that Trump has antagonized both sides of the aisle, don't expect Congress smoothly  to fall into line.  This means that debt will keep rising, but the ceiling won't. So the private sector has to be attracted to higher Treasury yields in order to buy the debt. The result will be higher rates induced by quantitative tightening. Yet another reason for our concern of "interest rate overshoot" that can choke America's already tinny improving Economic Time®.
  5. Investment implication. Expect negative emotions concerning a market turbulence to "bunch" as of 3Q '17, meaning that the market crash will occur between 4Q17 - 1H18.  Buy defensive high-yielding stocks, e.g. utilities,  as portfolio protection!

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