February 2021 – Monthly Commentary

February 2021

The bond market has struggled mightily of late with one unexpected “fire” flaring up after another, and despite demanding attention, the Federal Reserve has failed to act.   Of concern has been the downward trend in Treasury Bill yields over the last few weeks.  No one wants to see the yield for T-Bills go negative, but with the Treasury reducing supply temporarily to stay under the debt cap, the Fed buying in the secondary market and money market funds now effectively all government Bill funds, the yield has nowhere to go but down.

Contrary to what was happening in the Bill market, longer maturity Treasuries have been under selling pressure as investors are starting to worry that the Fed is letting the economy run too hot.  From that, signs have emerged that inflation may flare up.  When Chairman Powell testified before Congress in late February, he only served to worsen that fear.  On both days of testimony, the S&P 500 reversed big intraday drops on his dovish comments.  The street was whispering that he may suggest the possibility of curve flattening but instead his message was that the Fed will look past any transient inflation and continue to buy bonds for the foreseeable future.  As a reminder, the Fed is buying $1.44 trillion in the secondary market annually. 

He also failed to address issues in the money market.  The whisper prior to his testimony was that the Fed would raise the Interest on Overnight Excess Reserves (IOER) left at the Fed but they would communicate that it was technical and not a rate hike.  Unfortunately, he missed the opportunity and the upward trajectory of long end interest rates continued.

Against that backdrop, the most recent 7-year auction was an unmitigated disaster.  The auction cleared more than 4 basis point above where it was trading at the 1:00 auction time.  When auctioning Treasury debt, the Treasury allows the soon to be issued debt to trade several days before the actual auction in what’s known as the “when issued” market.  Dealers and investors can buy and sell the issues without paying for it until the official settlement date, which is the day after the auction.  This trading allows buyers and sellers to come in to balance so that at auction time there is no surprise.  Usually, the auction yield is nearly identical to that at which it’s trading at auction time.  When the auction clears at a higher yield than it was at auction time, it’s referred to as a tail.  At the last 7-year auction, the tail was one of the largest on record – 4 basis points.  On the news, the entire Treasury market when through a mini flash crash, as the long bond initially fell four points in price before recovering to retrace about one half of that move.

That’s an unheard of occurrence and should be a wake-up call to Congress and the Treasury department.  The U.S. has been running annual budget deficits on the order of about $1 trillion and will do so again this year.  Moreover, with the COVID stimulus bill being passed into law, that’s another $1.9 trillion that’s going to need to be financed through bond sales.  With investors showing indigestion from the deficits already financed, one wonders how they are going to finance future sales.

Separately, the financial press seized on the 10-year note repo trading as low as -4.00% during the first week of March.  Such a situation exists when the short sellers aren’t able to borrow the bond to make delivery.  It’s a situation that’s not unlike what happened to Game Stop last month, except for one big difference.  The Treasury will reopen $38 billion of the same 10-year note in the coming days, so investors shouldn’t expect any significant short covering rally. 

Lastly, Minneapolis Fed President Kashkari was quoted as saying that if real rates spike it may warrant more easing from the Fed, which is a little perplexing.  Real rates rise when the economy is accelerating and the Fed is either raising rates or is poised to do so.  Easing in such a circumstance would likely cause real rates to rise further.

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