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!



Share this post:

DISCLAIMER: THIS BLOG DOES NOT PROVIDE INVESTMENT ADVICE

The information, including but not limited to, text, graphics, images and other material contained on this blog are for informational purposes only and do not necessarily reflect the views or Enzio von Pfeil. The purpose of this blog is to promote broader understanding, knowledge and awareness of various financial and economic topics. It is not intended to be a substitute for regulated professional investment advice. Always seek the advice of your a regulated investment advisor with any questions you may have regarding your specific investment needs or concerns.

Enzio von Pfeil does not recommend or endorse any strategies or ideas mentioned in this blog. Reliance on any information appearing in this blog is solely at your own risk.

IT IS IMPORTANT THAT YOU READ, UNDERSTAND, AND AGREE TO BE BOUND BY THESE TERMS WHEN VIEWING, READING OR OBSERVING ANY INFORMATION, DATA OR ANY OTHER FORM OF COMMUNICATION ON THIS BLOG:

Any information provided to you by us, including any promotional material such as photographs, written descriptions, any plans or models, any income estimates or projections (“Information”) have been provided to us by other sources and although we aim to perform due diligence on all information we provide to our Blog subscribers, the Information is provided for general purposes only, we cannot guarantee the accuracy of the Information and we do not make any representations, either express or implied, as to the accuracy as to the Information. We recommend that our Blog subscribers undertake their own due diligence in relation to the asset they are considering purchasing, including seeking independent legal and financial advice in relation to their own financial objectives and personal circumstances, prior to signing any agreement or contract with any third parties.

No representation or warranty is given as to the accuracy, likelihood of achievement or reasonableness of any figures, forecasts, prospects or returns (if any) contained in the message. Such figures, forecasts, prospects or returns are by their nature subject to significant uncertainties and contingencies. The assumptions and parameters used by www.enziovonpfeil.com (evp.com) are not the only ones that might reasonably have been selected and therefore evp.com does not guarantee the sequence, accuracy, completeness or timeliness of the information provided herein. None of evp.com, its members or any of their employees or directors shall be held liable, in any way, for any claims, mistakes, errors or otherwise arising out of or in connection with the content of any form of communication, documentation included in the Blog, via e-mail or any other form of communication.

You are reminded that the content is for personal use and general information only. Under no circumstances is the content intended for and hence the content should not be regarded as an offer or solicitation or recommendation to dispose/sell, an offer or solicitation or recommendation to subscribe in, nor an offer or solicitation or recommendation to buy/acquire and under no circumstances should the content be constituted as provision of any recommendation or investment advice on any securities, investment products, investment arrangements and any other form of investments or legal, tax or other professional advice and therefore should not be relied upon in that regard for making any decision. Unless specifically stated, neither the information nor any opinion contained herein constitutes as an advertisement, an invitation, a solicitation, a recommendation or advice to buy or sell any products, services, securities, futures, options, other financial instruments or provide any investment advice or service by evp.com.

Unless stated otherwise, any opinions or views expressed in this communication may not represent those of evp.com. Opinions or views expressed in this communication may differ from those of other departments or third parties, including any opinions or views expressed in any research issued by evp.com.

Any e-mail and any accompanying attachments are not encrypted and cannot be guaranteed to be secure, complete or error-free as electronic communications may be intercepted, corrupted, lost, destroyed, delayed or incomplete, and/or may contain viruses. EvP.com, therefore, does not accept any liability for any interception, corruption, loss, destruction, incompleteness, viruses, errors, omissions or delays in relation to this electronic communication. If verification is required please request a hard-copy version. Electronic communications carried within the evp.com system may be monitored. Any communication or message in email form or otherwise may contain confidential information. Any use, dissemination, distribution or reproduction of the relevant information outside the original recipients of any messages  is strictly prohibited. If you receive a message by mistake, please notify the sender by reply email immediately and permanently delete the emails and its contents. Unless otherwise stated, any communication provided is solely for information purposes only.