Late on Thursday, when we commented on the implications of Mnuchin’s “political” decision to end various emergency facilities jointly operated by the Treasury and the Fed, including the muni liquidity program and Main Street lending program which many Wall Street strategist pointed out “present market disruption risks”, we said that the market is likely completely misreading this analysis, for the simple reason that less support from the Treasury – whether via Fiscal stimulus or helicopter money – means that the Fed will be required to do more, either in the form or more outright QE or expanded duration of existing debt monetization.
Overnight, Ben Emons, head of global macro strategy at Medley shared a similar view, writing that “the Fed may boost Treasury purchases and/or extend maturities of the securities it buys through its main QE program because of the dispute.“
Now, in his morning note, BMO’s chief rates strategist Ian Lyngen agrees with this take and writes that “there is little question that this increases the probability that the Fed pushes forward with an extension of the WAM of QE purchases at the December 16 FOMC meeting.“
Why is this important?
Because when it comes to capital markets, the Fed’s monetary policy – be it QE, YCC, or NIRP – is far more powerful and quick in raising risk prices, whereas any “spending-based” stimulus that goes through the Treasury is not only greatly diluted by the time it hits stock prices (after all it goes through the broader economy first), but it also raises the possibility of inflation. Remember: nothing crushes PE multiples faster than a jump in inflation.
In other words, while Mnuchin’s action may lead to an adverse impact for the broader economy, it is perversely stimulative for the markets. Or at least should be. Which is why today’s downbeat market response is – you guessed it – yet another dip buying opportunity for the army of 16-year-old Robinhood traders and/or Mnuchin’s immediate family which will be able to afford even bigger diamond rings.
Below we republish Ian Lyngen’s full note:
The opposing stances of Mnuchin and Powell on the extension of “the full suite” of bailout facilities has become the market’s primary focus as the weekend quickly approaches. Allowing the expiration of the corporate credit facilities (both primary and secondary) is the headline eyebrow raiser; however, ending the muni liquidity program and Main Street lending also present market disruption risks. We’re sympathetic to both sides of the argument; Powell advocates extending everything over year-end to ensure against dislocations whereas Mnuchin sees functioning in the credit and muni markets as sufficient and the monies would be better used as grants/bailouts. The question of ‘why not both continuing the facilities and providing further fiscal aid?’ falls well into the territory of the political and far afield from the tradition risk/reward calculations in financial markets. Alas, the fact of the matter remains that this debate is very much front and center as investors attempt to navigate the balance of 2020.
There is little question that this increases the probability that the Fed pushes forward with an extension of the WAM of QE purchases at the December 16 FOMC meeting. That said, it’s also incrementally encouraging that Mnuchin’s proposal includes the partial extension of the emergency facilities; perhaps leaving the door open (albeit slightly) for more flexibility with the remaining programs. Any further public comments on this issue in the coming days will allow investors a better sense of the balance of risks into the year-end turn. In the interim, it’s been impressive how limited price action has been in both US rates and global equities. To be fair, the bull flattening in Treasuries has been credited to the risk just such a scenario comes to fruition, thereby forcing the Fed’s hand via extending bond buying further out the curve.
We’re cautious of attempting to extract an overly bearish read on the fact Treasuries haven’t extended the bull flattening on the Mnuchin/Powell showdown, even if it’s tempting to put this episode in the crowded category of buy the rumor sell the fact in Treasury space. Simply concluding the issue has been ‘fully priced in’ at this stage is needlessly glib in light of the array of potential combinations of what programs ultimately get extended and how Congress chooses to utilize any freed up emergency funding. With all the caveats dutifully offered, it’s still encouraging that 10-year yields were unable to dip as low as 80 bp and appear to be stabilizing closer to 85 bp. This price action has occurred despite the building consensus that Fed action next month is much more likely than not and it will, by design flatten the curve and limit any decisive bear steepening.
This reality doesn’t entirely negate the underlying fundamentals that continue to support the potential for gradual upward pressure on yields further out the curve. That said, the prospects for a WAM extension in December and an outright increase in the size of bond buying beyond $80 bn/month at some further point if the situation warrants does limit the degree to which 10- and 30-year yields can back up over the next 12-18 months. This by no means takes 1-handle 10s off the table; in fact, incorporating more official buying further out the curve clears the proverbial deck for an attempt to price in a round of optimism for the year ahead.
It’s a no-data Friday with the overhang (can we stop calling it a benefit yet?) of working from home as the holidays rapidly approach. Cyber deals, coupon codes, free shipping, free returns, and that annoying little countdown clock that implies heavily discounted items are temporary aberrations rather than an initial misprice/overstock are much better positioned to occupy the market than the choppy price action and dueling policymaker headlines. Perhaps we’re just projecting… again. Nonetheless, the weekly closes in 10s and 30s will merit attention, if for no other reason than the technical implications as month-end and the holiday shortened week approaches.
Tactical Bias:
In addition to the unknown of any potential adjustments to the QE program that may be announced at the December 16 FOMC meeting, we’ve been contemplating what the next trend will be in terms of market moving developments over the next several quarters. At present, that designation rests squarely on the path of the pandemic, however as inoculation eventually proceeds and greater collective immunity develops, there will come a time when case counts fade as the timeliest tradable information. It is at this point we suspect the economic data will once again emerge as relevant for rates. Not necessarily as a function of Treasuries responding to the inherently backward looking information, but rather as an update on what hiring, wages, spending and inflation will look like the post-covid novel norm.
As has been exemplified by the collective disinterest in the fundamentals over the past few months, pre-second wave spending patterns are of little consequence when it comes to assessing what the world will look like once a vaccine becomes widely available and adopted.
We are of the mind regardless of the level of government restrictions, individuals will remain reluctant to resume spending in a fashion that was the norm in 2019. This means that presumably at some point in mid-2021, when vaccinations are widespread, the data will capture what growth and inflation – and thus Treasury yields – look like as the second half of the year unfolds and more information is in hand. An extension of the increase in goods spending would follow in such a world. Additionally supportive of this trend is a nuance surrounding the nature of consumption that has been deferred as a result of the pandemic.
Unlike goods spending, many service expenditures will not benefit from pent up demand that has accumulated over the period spent at home. Households will not double the amount of restaurant visits they make or move theater trips they take versus the levels that were the norm before Covid-19. Rather, a return to those levels seems to be a best case scenario given the lingering uncertainty, which in practical terms lengthens the time of the recovery and will ultimately limit the degree to which 10- and 30-year yields will be able to rise.
This doesn’t paint an especially uplifting outlook for the prospects for a trending market in US rates. Instead, the realities imply 1) the curve shape is little more than a directional trade, and 2) the duel between economic optimism and persistent headwinds will leave trading the extremes of the range as the most prudent strategy as the global economy slowly begins to emerge from the pandemic. There will continue to be sectors that are decided winners and losers; even if the prospects for a ‘relatively’ swift return to normal may ultimately save industries that might have been in greater jeopardy had lockdowns persisted for several years.
