Halyard’s Weekly Wrap – 09/02/22 – Negative Carry is Starting to Bite!

Economic data this week offered a reprieve from the recent trend of weak indicators.  This morning’s employment report for August was especially cheering.  Economists had been looking for the economy to add 298,000 jobs in the month, following last month’s 528,000 add.  We were skeptical that August would follow with an above trend outcome, but we were proved wrong by a print of 315,000 new jobs.  Ironically, bond prices rallied across the curve on the news in a case of “sell the rumor, buy the fact.”  Earlier this week whisperings of an outsized employment report began to circulate.  Anticipating that possibility, the two-year note yield touched 3.50% with the thirty-year yield topping out at 3.36%.

Hedge funds were purported to have led the selling, driving the long bond rate 16 basis points higher for the week.  It’s important to keep negative carry in mind when evaluating a fixed income short.  Negative carry is the expense of carrying a fixed income short and is calculated as the yield-to-maturity of the short (cost) less the cost of borrowing the bonds to short (income).  To use the two-year note as an example, a short incurs the 3.41% expense which is partially offset with the 2.3% income for a total expense of 1.11% per annum.  That expense is a disincentive to hold the short position for any material amount of time, which is directly impacting the recent volatility in the rates market.  An alternative would be to sell fixed income futures since the contract doesn’t need to be borrowed to be sold.   While that is technically correct, through the magic of arbitrage, the same expense of shorting a cash bond is imbedded in the pricing of a future.

The cost of shorting interest rates will become even more focused this month as quantitative tightening (QT) reaches its full capacity.  As of September 1st, QT will increase to $96 billion per month in Treasury and mortgage-backed securities rolling of the Fed balance sheet.  QT commenced in June and, arguably, has had little apparent impact on the secondary market, but with the size of the operation increasing from $47.5 billion to $95 billion a month, the impact is likely to be felt.  We’ll be watching for signs of the operation pushing interest rates higher.  It’s important to remember that there continues to be a massive amount of liquidity in the system and despite the encouraging economic news this week, the economy continues to suffer a down-tick in activity of interest sensitive sectors like home and auto sales.