Note: Considering the potential market fluctuations throughout the COVID-19 Pandemic, it should be noted this article was originally written on 3 June 2020
A few weeks ago in May, the US treasury announced a record high $96 billion quarterly refunding driven by the Covid-19 emergency stimulus. This compares to $84B from last quarter, an amount which held for the previous 5 quarters. So how does a former Goldman Sachs Banker, who is one of the longest-tenured cabinet members in Trump’s administration, decide to structure such debt in such crazy times? In other words, how does Mnuchin, the U.S. treasury secretary, think? Mnuchin, in my opinion, is one of those silent assassins you generally want to stay away from. He is as stoic as he is cunning. The guy who never shows his emotions, in my experience, is the one who is usually one step ahead of everyone else (think Bradley Cooper in Limitless but less attractive).
Mnuchin is thinking “borrow now, and pay wayyyyyyy later”
More specifically, the treasury announced the first 20-year term issuance since the 1980s (when I was born). So the U.S. government is issuing debt today, that will pay you interest semi-annually every year, but won’t pay you back principal until 2040. Why wait 20 years to pay you back? Because the U.S. government doesn’t have enough money to pay you back sooner, plain and simple. The U.S. deficit is set to quadruple this year to almost $4 trillion. Yes, the refunding does issue debt on each point of the curve (more on that shortly) but the majority of it was 10 years and up, which is already enticing because of the record low yields currently around the world. My initial color on this move from a market perspective was that investors should likely see a steepening in the yield curve on the long end – meaning the difference in yields from the 20-year (and likely 30-year) points on the curve from the 10-year point should increase. If finance jargon like “yield curve steepening” doesn’t make sense to you at first, click here for a quick refresher (or introduction).
You might ask, why would the yield curve steepen after such a move? The answer is simple: supply and demand. If the treasury issues new debt and issues more on the 20-year point of the curve than anywhere else, there is excess supply on that point of the curve. If there is excess supply, we know from Econ 101 that, in general, price goes down to meet demand. In bond math, when price goes down, yield (rates) goes up. So in this case, when the 20-year treasury yield goes up more than the 10-year treasury yield goes up, this is considered a curve steepening. Just think of it as a line that connects the 10-year and 20-year points that is more vertical than it was before, as illustrated in the U.S. Treasury Yield Curve below, with term in years on the x-axis and percent yield on the y axis. The red line is the yield curve from 6/1 and the blue line from 5/7:
Whenever we talk about yields, we also need to talk about the Fed. The Fed announced in late May it would lower its quantitative easing (QE) program of buying securities to a pace of about $4.5B per day in the first week of June, down from about $5B per day the week before. This ties into why Mnuchin is issuing long-dated debt – the Fed reinstituted QE and pushed long-term rates down to ease the cost of borrowing. Apparently private companies aren’t the only entities who leverage this. The U.S. government does, too. But as the Fed lowers QE per the last statement, back to Econ 101, it reduces demand for treasuries in the market, and less demand should also decrease the price of bonds, which should in turn increase yields. Furthermore, Mnuchin has already voiced that Congress will very likely need to pass more stimulus legislation as the U.S. economy struggles to come back from the coronavirus effects. So if further stimulus gets passed, the treasury undoubtedly will need to issue more debt to fund it, which leads to an interesting conundrum of increased supply of treasuries (again more stimulus and related treasury issuance) and decreased demand (Fed presumably continuing to lower QE) resulting in a type of double-whammy economic effect of lower bond prices and higher yields precipitated by both sides of the demand/supply equation.
To be fair, many economists do not see such a future (higher overall rates). Some are calling for a more European/ Japanese approach to Central Banking to be utilized by the Fed, which is basically 1) “Do whatever it takes” (Europe, negative interest rates) or 2) Yield curve control (Japan, and negative rates, too). Yield curve control is exactly what it sounds like – instead of the Fed announcing how many treasuries it will buy per day, it will state a decision rule like “the Fed will purchase as many treasuries as necessary to keep 3-year yields at 0.50%”. If we are to assume that the Fed will be influencing yields to spur the economy, then I understand how one could surmise why not just be very specific and direct in the ends rather than the means.
However, Japan’s story of yield curve control was more to boost persistently low inflation, not drive a country out of a pandemic-related recession. There are also material differences in macroeconomic factors between the U.S. and Japan that affect growth and related inflation – the latter has objectively low birth rates and low immigration, while the U.S. is higher on both accounts. The underlying reason for the Fed to consider Yield Curve Control is different than Japan’s, and the economies themselves are different, so we should not look at Japan as a demonstrative example of potential outcomes, in my opinion. And in Europe, negative interest rates were generally used to spur consumer spending, which is not really an issue in the U.S., at least from a demand side analysis pre-COVID. Much of the protests to reopen the economy, I think, encapsulates, at least qualitatively, that consumers want to spend – it’s the supply-side restriction of shelter in place that is lowering production. And to state the obvious, negative rates also do not help consumers spend if they do not first have a job that enables them to spend.
So what does the Fed do? This is the ultimate conundrum in my opinion, and also leads to a greater question: Why does the Fed have to do anything? We are currently in a precarious political and market environment, induced by the financial collapse of 2008 and related Central Bank intervention to revive global economies. Investors cannot consistently look to the fed, or central banks in general, to determine future economic outlooks. The market should be driven by one thing: the market.
But as David Spika, president of GuideStone Capital Management said recently, “The markets have become addicted to stimulus. That is the key factor that is going to continue to drive risk appetite, just like it did in the last cycle.”
This is short-termism at best and long-term economic implosion at worst. Consistent economic stimulus inflating asset prices, instead of market forces, will eventually either blow up when central banks run out of ammunition (a difficult scenario to presume but actually plausible if central banks continue to execute with their current strategies), or result in supermassive inflation. It’s a harder pill to swallow, but letting the market actually correct itself – yes, I mean bankruptcies, defaults, etc. – might be better long-term than pretending we can always bail everyone out. This isn’t necessarily an indictment of capitalism, it’s a reproach of consistent and ever-increasing government intervention on capitalism, similar to Chamath Palihpaitiya’s opinion here. There are too many market forces, with both endogenous and exogenous factors, for any one individual or institution to be able to consistently manipulate successfully. This is the argument for unobstructed capitalism at its heart.
Initially I disagreed with Chamath but now I tend to agree. If we refuse to let the market correct itself and are dead-set on bailouts, then the compromise should be that money should go directly to individuals, not corporations or securitized assets, and then consumer choice should correct the market through natural demand changes. Only worrying about the price of assets, instead of the fundamentals that should drive such prices, could prove to be a massive mistake and seemingly undercuts many of the tenets of capitalism itself.