As part of the Treasury’s Q3 refunding announcement, which as discussed earlier sent 30Y yields to session lows after it failed to either boost upcoming debt issuance or mention ultra-long dated bonds, the Treasury Borrowing Advisory Committee or TBAC, a select group of bankers from Wall Street’s biggest firms tasked with providing periodic guidance to the Treasury, released its latest presentation, whose topic this quarter was “Normalization of SOMA Portfolio“, or a breakdown of i) how Wall Street expects the Fed’s balance sheet reduction will play out from a chronological and structural basis, ii) how treasury issuance will be impacted as a result, and most importantly, iii) the expected impacts on markets.
The full agenda was as follows:
1. Expectations for balance sheet normalization
- When will Fed start phasing out Treasury holdings?
- What will be the size of Treasury holdings once the Fed balance sheet is normalized?
2. How will the Fed distribute eventual Treasury purchases across maturities?
- Expectations for resulting Treasury issuance
- How large will Treasury’s financing needs be? When should Treasury start increasing auction sizes?
- What will be the impact on auction stop-out rates?
- What is the recommended distribution across tenors for higher financing needs?
3. Market implications of balance sheet normalization
- Will SOMA redemptions have disruptive secondary market impacts?
- What will be the impact on financial markets overall including risk assets?
- How will the repo market be impacted?
On topic one, the key highlights were the following expectations:
- The FOMC will announce a phasing out of Treasury and MBS reinvestments at the September FOMC meeting to start October 1st, 2017.
- The balance sheet will reach normal levels by 1Q 2021.
- At time of normalization, Treasury holdings to be $1.7 trillion, down from $2.5 trillion now.
- The Fed’s holdings of Treasuries will grow by $100-200bn per year post normalization.
- The impact on 10y premiums should be 40bp over the period.
While we will follow up with more detail on point two shortly, what we found most interesting in the presentation, was TBAC’s discussion of how the Fed’s normalization will impact markets. As the following takeaways from the presentation note, the TBAC – and thus Wall Street – is far less sanguine about how the Fed’s balance sheet reduction will play out.
In a process which it calls “Linear Normalization with the Potential for Nonlinear Credit Risks“, the TBAC highlights the following key highlights, which among other things, finally admit that the collapse in yields has prompted a surge in equity buybacks, or what it dubs “pure financial engineering” but even more notable is part 3: the TBAC’s take on “letting markets clear“, where it warns that “a downside risk in a stress scenario is a meaningful decline in risk assets.“
- Part 1: Risk premium compression. Central bank balance sheet expansion, declining bond risk premium, and lower yields induced rising investor bond demand and tighter credit spreads. Corporates filled the demand gap with a surge in borrowing used for equity buybacks. Pure financial engineering.
- Part 2: Risk Premium decompression, accelerators: Small increases in yields can potentially lead to large changes in risk premium. Credit is the key transmission. Pro-cyclical behavior of investors who ‘piggy backed’ central bank purchases and ECB tapering are possible accelerators to the rise in US risk premium in a tail risk event.
- Part 3: Let markets clear. A downside risk in a stress scenario is a meaningful decline in risk assets. But it isn’t systemic. Banks and households have not leveraged to higher asset prices. It is a financial engineering shock.
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On the first topic, the TBAC points out that risk premium have declined with lower real yields, counter to historic norm of risk narrowing with higher real yields
More importantly, the TBAC also warns that with IG corporate net leverage near all time highs, the result of “expectations of permanently lower rates and tight spreads”, they are “more sensitive to higher rates.” In other words, a sharp, or even gradual, rising yields will impact corporate debt disproportionately.
An even more troubling slide follows, one which touches on what we discussed nearly two months ago, namely the upcoming substantial mismatch between bond demand and supply, which will result in a larger private risk premium, and will be “More challenging than the 2013 tantrum.“
Once yields spike, the next move will be an inevitable outflow from bond funds. Here the TBAC warns that “redemptions from bond funds have a large impact on corporate bond spreads, amplifying the rise in credit spreads” and points out that just a 1% net outflow from bond funds in 2008 “was the shock in October 2008.“
Finally, the TBAC is prudent enough to point out that it is not what the Fed does as much as the ECB, which over the next year is expected to engage in aggressive tapering. It writes that while “ECB asset purchases compressed German real yields and lowered yields in the US” it is already working in reverse. This is the same risk that many other standalone banks, including Citi, JPM and Deutsche have warned about in the past.
Putting it all together is the slide TBAC prudently saved for last, which lays out how a potential “stress scenario” could play out. According to the TBAC, the “amplification from normalization could possibly come from wider credit spreads and be transmitted to equity buybacks and valuations.” In other words, higher yields, higher credit risk premium, higher volatility, lower risk prices, market crash.
Among the major catalysts in this pathway envisioned by the TBAC are:
- Rise in corporate financing gap to 1% of GDP through Q1 2018 (+50bp)
- Amplification from bond redemptions (+100bp)
- Causality from credit spread to volatility rather than VIX exogenous
- Credit spread has an embedded short equity put
- VIX +10 points from wider credit spreads
- Equity risk premium rises ~40%
- Partial pass-through of higher equity risk premium
Obviously, if the TBAC is comfortable with putting out this dreary forecast for public consumption, what it is really thinking in terms of a “worst case scenario” is significantly scarier for markets.
Full presentation below (link).
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