Have you ever considered how the US Treasury decides how much debt to sell each month to raise the cash it needs to pay its bills in full? If you are like 99.9% of us, probably not. But for investors and traders, it’s important.
Treasury supply has a direct impact on not just bond yields, but also stock prices. In fact, it is one of the largest impacts. Last month the Treasury dumped over $100 billion in new short term T-bills on the market. Banks, institutional investors, and most importantly, dealers must absorb that paper. The cash to buy the paper must come from somewhere. When that much new supply hits the market in a month, it inevitably causes pain, as some of the buyers usually need to liquidate other paper to buy the new paper.
So it was last month as Treasury bill rates rose, bond yields rose (prices fell), and stock prices fell. The big slug of new Treasury supply was not the sole cause, nor even the major cause, but it was a contributory factor. It tilted the playing field in the bears’ favor, just as other money market conditions were deteriorating.
Fortunately for us, the Treasury actually gives us a roadmap of how much supply to expect at every single auction, weeks and months in advance. It does so through a report issued by the Treasury Borrowing Advisory Committee. This is a committee of Primary Dealer executives which the Treasury appoints to provide market guidance. They like to shorten that name to TBAC.
The Primary Dealers are actually the guys who run the bond markets. They’re the dealers selected by the Fed to act as the sole counterparties to the Fed in its execution of monetary policy. When the Fed is buying bonds under QE, it buys the bonds from the Primary Dealers. The dealers then transact business with their parent banks, with other dealers and institutional customers. That’s how the money gets into the banking system and the economy.
The Primary Dealers are also required to make markets in US Treasury securities. They’re on line with the Fed and the US Treasury all day every day. In effect they run the markets. They are the conduits through which all monetary policy actions and all Treasury actions hit the markets.
In short, they know stuff.
The TBAC issues a report to the Secretary of the Treasury every 3 months, in August, November, February, and May. Each report lays out the expected amount of money that will need to be raised over both the current quarter in progress, and the next quarter. The November report was just issued. It revised the outlook for November and December and issued the first estimate for the January-March 2017 quarter.
The Treasury generally follows the TBAC recommendations, particularly for note and bond issuance. If the Treasury runs short of funds, it typically will increase short term T-bill supply, rather than play with note and bond issuance.
So the insiders typically know exactly what to expect in terms of bond supply headed their way. But we also know. This report isn’t top secret. It’s public. It’s well hidden, but if you know where to look, it’s findable. I found it years ago, and have been reporting on it regularly ever since. It gives us a leg up.
These reports always follow the same format. First it discusses recent past economic and market conditions. Then it addresses what it expects to lie ahead in the near term. It then discusses expected supply needs, and finally any specific issues requested by the Treasury. They are also important in that they give us insight into how the Primary Dealers view the economy and the market, or at least the propaganda. It’s always an interesting read, and maybe even useful by showing us they’re thinking.
In the report issued November 2, the TBAC was once again very bullish. What else is new? It’s par for the course.
Since early August, financial conditions have tightened modestly but remain accommodative, with mortgage rates little changed, equity prices slightly lower, and the exchange value of the US dollar having resumed strengthening. The drags from an inventory overhang and declining activity within the domestic energy sector appear to be waning. Meanwhile, household spending is supported by favorable fundamental factors, including healthy balance sheets, healthy employment gains, and improved wage prospects. Looking ahead, these factors point to a sturdy backdrop for the ongoing economic expansion.
Household balance sheets have been buoyed by rising home prices, the improvement in equity wealth in recent years, and disciplined debt growth. Those strong fundamentals, combined with ongoing gains in employment and wages, suggests household spending will continue to carry the expansion in the coming quarters.
The fallacy here lies in the assumption that house prices and stock prices will stay high. However, then they noted the contradiction that:
Nonresidential fixed investment edged up in the third quarter at an annual rate of 1.1%, reflecting mixed contributions from the major categories. Equipment investment declined for the fourth consecutive quarter, which is unprecedented outside of recessions.
The committee noted bearish factors in housing, but concluded that housing would grow anyway based on the assumption that low mortgage rates would continue to be a driver. The fact of steadily rising bond yields since July apparently escaped them, in spite of the fact that they run the bond market.
Residential investment fell for the second quarter in a row, as the housing market expansion has paused this year. However, ongoing gains in household formation and historically low mortgage rates should support activity going forward, even if high and rising home prices crimp overall affordability.
They said that they expect trade to improve, except if it doesn’t.
These factors bode well for foreign trade going forward, provided US dollar appreciation is contained and tensions among trading partners are managed.
They expect fiscal policy at all levels to remain stimulative. They understand that deficit spending gooses the economy, but they fail to consider the impact of interest expenses down the road. Deficit spending, which is spending borrowed money, certainly boosts the economy’s adrenaline in the short run. But watch out when interest rates rise and the cost of carrying the debt becomes a greater drag on the economy.
For the past 7 years of ZIRP and QE, taxpayers have gotten a free ride on that. To assume that the level of stimulus from deficit spending will remain as high as it is means that you must also assume that interest rates and bond yields won’t rise. The market is on the verge of disabusing the bulls of that assumption.
The committee spent a paragraph on the inflation outlook. It was contradictory, “on the one hand—on the other hand,” gobbledygook. They don’t know what to think about it. Like the Fed, they still pay most attention to the PCE, which is the most suppressed of all inflation measures. No one seems to want to recognize that inflation as correctly measured to include housing inflation has been running above the Fed’s target of 2% ever since the Fed announced the target in 2012, as covered here.
The TBAC then gave lip service to the FOMC meeting statements with a sentence notable for its length and convolution:
The most recent FOMC statement noted risks to that outlook were “roughly balanced.” That said, policymakers seem intent on proceeding cautiously given an asymmetric ability to respond to new economic developments because the target federal funds rate remains close to the zero lower bound, and an increasing realization that equilibrium interest rates are historically low, and thus the stance of policy may not be as accommodative as the level of the federal funds rate would have historically implied.
Say what? I really liked the phrase, “an asymmetric ability to respond to new economic developments because the target federal funds rate remains close to the zero lower bound.” That’s just another way of saying that the Fed is out of bullets. If the economy weakens from here, tough luck.
Next they discussed the tax shortfall in Q3 and estimated the government’s borrowing needs for the fourth quarter of 2016 (fiscal Q1) and Q1 of 2017 (fiscal Q2).
During the third quarter of 2016, corporate tax receipts have been weaker than during the equivalent period last year, potentially attributable to the extension of bonus depreciation and weaker corporate profits. In FY 2016, Treasury net outlays were $166 billion higher than in FY 2015, primarily attributable to increased HHS payments which partly owes to a one-time calendar shift. The budget deficit for FY 2016 was $148 billion higher than the FY 2015 deficit.
Here’s a question. If the economy is strengthening, why is the deficit growing?
Next came the forecast of needed borrowing so that the Government could pay its bills.
Based on the Quarterly Borrowing Estimate, Treasury’s Office of Fiscal Projections currently projects a net marketable borrowing need of $188 billion for the first quarter of FY 2017, with an end-of-December cash balance of $390 billion. For the second quarter of FY 2017, net marketable borrowing need is projected to be $56 billion, with a cash balance of $100 billion at the end of FY Q2.
The TBAC estimated net (new) marketable borrowing of $188 billion in the current quarter, including the amount already done in October. This was the second and final estimate for the October-December period. In the first estimate, posted in early August, they had expected net borrowing for this quarter to be $182 billion. They expect the fiscal year budget deficit to shrink by $220 billion versus the 2015-2016 fiscal year. That is an incredibly bullish forecast, and certainly unlikely.
The Treasury had tasked the TBAC with analysis of the likely impact of the new money market rules just implemented where prime funds will fluctuate in price based on daily changes in the money market. The discussion in the report was long winded and highly technical, all to reach the conclusion that some money market funds shifted out of commercial paper and into Treasury paper in order to avoid the rule.
The commercial paper (CP) market has therefore shrunk, pushing CP rates up. Increased demand for Treasury bills should push rates down in the T-bill market, according to the report. The impact was seen as being around 15-35 basis points.
That seems like an argument over how many angels can dance on the head of a pin. Why are we even discussing a difference of 25 basis points? It would hardly have a material impact on the US economy. Meanwhile T-bill rates did not fall in October. They rose.
The report hit on a subject that has been near and dear to my heart for the past several years. I have ranted and raved that the Fed’s attempt to control short term interest rates via the interest it pays on excess reserves (IOER) is really a US taxpayer subsidy to the banks.
Reserves are the deposits that the banks hold at the Fed. Under the policy formerly known as QE, the Fed bought Treasuries and mortgage backed bonds (MBS and GSE) to increase the amount of cash in the system. It did so from 2008 until late 2014. We called the gradual reduction of those purchases “The Taper.”
The Fed actually created the excess reserve deposits on which it pays interest (IOER) when it bought the bonds from the Primary Dealers.
The Fed paid for the bonds it bought from the Primary Dealers by making a deposit in the banks’ deposit accounts at the Fed. Those deposits totaled some $2.1 trillion. That’s not money that the banks earned. It’s money that the Fed waved into existence with its magic money wand and handed over to the banks. After handing the free money to the banks, the Fed pays the banks’ the IOER on the free money it just gave them.
Nice work if you can get it, but it’s strictly for the banks. Ordinary people can’t get it. In fact we pay for it.
Normally, the Fed earns a surplus (aka “profit”) from the interest it receives on its holdings of Treasuries and MBS. It turns that surplus over to the US Treasury each month. This surplus totals approximately $80-100 billion paid back to the US Treasury each year. It’s a savings to the taxpayer
However, the additional money which the Fed pays the banks when it increases IOER reduces the Fed’s surplus which it sends to the Treasury and which would normally apply to reducing the deficit. This imposes an additional cost on taxpayers.
Taking money from US taxpayers to pay the banks a direct subsidy which they did not earn in any way is outrageous. It is just one more example of an out of control central bank working to the detriment of the American people.
The TBAC is comprised of the executives of the Primary Dealers who most benefit from IOER. They said this in discussing the shrinkage of the commercial paper market:
Over the past year, the market has decreased by $118 billion, led by the drop in foreign financial borrowing. Some of that decline should have no noticeable market impact because foreign banks were merely issuing at levels below the Fed’s interest rate on excess reserves and then placing the proceeds with the Fed to earn IOER.
In other words, foreign banks, the biggest of which are also Primary Dealers, issued CP at rock bottom rates, then placed the funds at the Fed to skim the higher rate which the Fed was paying. The Fed encourages this scam by arbitrarily offering that higher rate. To quote a famous sportscaster, “It’s an outrage.” We are shipping taxpayer funds overseas to help subsidize European banks.
Come to think of it, 15 of the 23 Primary Dealers are foreign banks, including 8 European banks. Makes you wonder. Who is the Fed really working for?
See more Treasury market indicators and their impact on the stock market in Lee’s Wall Street Examiner Pro Trader Report. Lee first reported in 2002 that Fed actions were driving US stock prices. He has tracked and reported on that relationship for his subscribers ever since. Try Lee’s groundbreaking reports on the Fed and the forces that drive Macro Liquidity for 3 months risk free, with a full money back guarantee.
