The Fed tapering could be a fantasy as a string of economic data disappoint, from slowing retail sales, tepid manufacturing demand, plunging consumer sentiment, and not to mention the ratcheting up of the delta variant fear-mongering by the mainstream.
But here is the problem; the Fed’s bond purchases, known as quantitative easing, which is the opposite of Fed taper, when the central bank sells bonds, is causing the long bond prices to rise and their corresponding yield to sink US 10 Year Treasury Note yield is 1,27%, at the time of writing this piece, down 32.86% in three months.
So if Fed tapering, the central bank cutting its 120B dollars of bond purchases is not on the cards, although the Fed will try and keep up the pretense of tapering until nobody believes it, then that raises an interesting question.
“Fed tapering could be a fantasy as a string of economic data disappoint, from slowing retail sales, tepid manufacturing demand, plunging consumer sentiment”
WEALTH TRAINING COMPANY
Why would the Fed be worried about negative yielding treasuries and pretend that the Fed taping is for real?
Think about it. If treasury yields were ever to go negative, then owning treasuries, which is considered prime collateral, would become a liability to own.
Moreover, treasuries are used as collateral amongst commercial banks to raise loans. But if the collateral is considered less valuable then creditors, in this case, commercial banks, would demand more collateral to secure the loan.
So the borrower would have to sell assets and raise liquidity to meet collateral requirements. So when that is done on a macro level you have the making of a liquidity crisis, similar to what played out in the 2008 financial crisis.
US treasuries are a pillar of global finance, unlike subprime mortgage-backed securities. So negative treasury yields could be more problematic than the last credit crisis.
“US treasuries are a pillar of global finance, unlike subprime mortgage-backed securities”
WEALTH TRAINING COMPANY
How will the Fed prevent rates from going negative while smashing down the long end of the curve, without Fed tapering?
First, we need to familiarise ourselves with a few basics in the Repo market and know the difference between reverse purchase agreements or reverse repo and repurchase agreements or Repo.
Reverse Repo is when Fed borrows cash from financial institution provides them collateral it pays them interest for the privilege of borrowing. The cash is borrowed overnight at 5 basis points or 0.05%
A Repo loan is the exact opposite of that, which is when the Fed lends cash and charges interest.
“instead of selling treasuries to raise US dollars investors are borrowing on the Repo market” – Wealth Training Company
There is also foreign Repo for foreign commercial banks. So banks that meet Fed criteria can get cash.
Standing Repo means that any financial institutions, both foreign and domestic, which meet the Fed’s criteria can access dollar loans at an annual interest rate of 0.25%.
Notice how the treasury 10y yield is greater than the Fed’s Repo rate, so these financial institutions can borrow from the Fed and buy treasuries and remain cash flow positive. For example, if the borrowing rate is 0.25% and the return on the US 10yr is 1.26%, the difference is 1.01% on the deal.
So instead of selling treasuries to raise US dollars investors are borrowing on the Repo market.
But the dam breaks if treasuries yields go negative or below the Repo rate of 0.25. No investor will borrow money and invest in an asset that provides fewer returns than the cost of servicing the debt.
So if the Fed tapering is not an option, then how will the Fed get short-term rates up, in a backdrop where the treasury isn’t issuing more bills, and the Fed doesn’t have balance sheet capacity to flood the system with T bills.
“Retail sales fell 1.1% in July, as demand from consumers is also falling as people come off unemployment benefits” – Wealth Training Company
One solution is for the Fed to persuade investors to sell their treasuries, which would send the price of the bill lower and yield up.
If enough people sell T bills rates go up. If the Fed can get short-term rates above 0.05% people will go to the markets instead of reverse Repo.
Short rates rise capital will flow from Fed trying to drive short rates up, and they are doing it to sacrifice long rates they have no choice.
Another reason why Fed tapering is unlikely is that Fed chair Powell’s tenure expires in February, and there is no way the Fed will taper before that date
Until we know who is the next Fed chair and the midterms are over don’t plan on Fed tapering.
As explained above, economic data shows that would not be possible.
A slowdown in China industrial production to 6.4% year on year, Retail sales slowing.
NY Empire State Manufacturing Index is slowing from 43 to 18.3.
New orders are slowing, shipments are slowing, which is also seeing demand slowing down.
Retail sales fell 1.1% in July, as demand from consumers is also falling as people come off unemployment benefits.
Moreover, next month, September, seven and a half million people lose all their benefits, and retail sales are already plunging. Consumers are 70% of the economy.
So Fed tapering could be just a lot of hot air
More like quantitative easing to infinity.