T-Bills Headed for 0% May Force the Fed’s Hand
(Bloomberg Opinion) -- The Federal Reserve decided not to extend the weighted average maturity of its asset purchases at its meeting this week, with Chair Jerome Powell arguing that longer-term interest rates are already plenty low enough to bolster the economy through what are hopefully the final months of the coronavirus pandemic.
While many in financial markets were scrutinizing the potential implications of lowering 10- and 30-year yields, those who closely watch front-end interest rates were asking a much different question: What will the Fed do to keep short-dated Treasuries from hitting zero? That is to say, they had fewer qualms about the central bank buying a greater share of long bonds and bigger concerns about it not easing up on purchases of short-term securities.
You’d be forgiven for not paying too much attention to two-year Treasury yields, or the interest rates on even shorter-dated T-bills, which are the asset of choice for money-market funds and have traded in a minuscule range over the past six months. But zooming in, there’s no mistaking that these rates continue to grind lower, even as longer-term yields try to break higher. Without something to break the trend, this could quickly become an issue for the Fed, which has come out about as forcefully as it could against negative interest rates.
Part of the story is the persistent weakness in the U.S. dollar, which keeps setting new recent lows. A simple six-month chart that plots the two-year yield against the Bloomberg Dollar Spot Index shows a strong positive correlation of 0.684 (a value of 1 means they move in perfect lockstep, negative 1 means they’re perfect opposites). There seems to be a feedback loop at play between the two markets.
But a number of behind-the-scenes factors are also working to bring down short-end rates. Bank of America Corp. strategists Mark Cabana and Olivia Lima have been out in front of this for weeks, arguing earlier this month that a sharp decline in the issuance of Treasury bills, combined with an increase in bank reserves caused by the Treasury Department drawing down its cash balance with the Fed, will create a supply-demand imbalance so large that if it’s left unchecked, short-term Treasury rates could drop to 0% or lower.
The Fed doesn’t want that to happen, full stop. For one, it would potentially decimate the critical $4.34 trillion money-market industry. The funds already yield next to nothing and have been steadily losing cash since May — a rate of zero or less could very well encourage a mass exodus. Also complicating matters, the Treasury isn’t allowed to auction bills at negative rates.
Bank of America has some suggestions for the Fed. First, it could simply increase its interest rate on excess reserves, known as IOER, which is now 0.1%. That would create a greater incentive for banks to keep money parked at the central bank rather than gobble up shorter-term Treasuries, or at least push the market rates up slightly. Bloomberg Intelligence strategists Ira Jersey and Angelo Manolatos wrote Thursday that a five-basis-point boost could do the trick and that the central bank would likely spring into action if the fed funds rate falls to less than 0.07% on a lasting basis; the effective rate is at 0.09% now.
Another option: The Fed could sell short-dated Treasuries outright or allow bills to roll off its balance sheet as they mature. That, of course, effectively amounts to the same thing as extending the weighted average maturity of its bond purchases — the very same policy that officials chose to eschew this week. “The case for a Fed UST WAM extension is strengthened if it considers money market dynamics but we do not believe the Fed has seen sufficient evidence to justify such an action at this point in time,” Cabana and Lima wrote on Dec. 3.
After the Fed decision, I compared the central bank to a football team with a strong defense that prudently chose to punt. The same analogy applies when looking at front-end rates. It’s certainly possible that the central bank will need to alter the composition of its bond purchases to tame interest rates on T-bills sometime next year. But there are enough lingering questions out there, from the size of the next fiscal aid package to an earlier-than-expected debt-limit deal, to make staying the course the smartest policy.
Besides, Janet Yellen will most likely be the Treasury secretary when the Fed and Treasury need to navigate these various cross-currents together. “We expect greater Treasury and Fed cooperation on front-end dynamics given Yellen’s deep familiarity with money markets,” Cabana and Lima wrote. “We are confident the Fed and Treasury have adequate tools to keep front-end rates above zero, but do not expect them to act until markets force them.”
So far, short-term Treasuries haven’t reached a tipping point. Two-year yields, at 0.123%, are still higher than the 0.103% level reached in May. Shorter-term bills had negative rates during the worst of March’s market meltdown and dipped to 0% in previous years. It’s possible that just as the threat of Fed action is enough to keep longer-term yields from roaring higher, that same psychology may also work to prevent a race to zero on the short end.
Still, front-end rates have a way of forcing the Fed’s hand in a way that longer-term yields don’t. Investors may quibble about whether a 1% or 1.25% or 1.5% yield on 10-year Treasuries is enough to get the central bank’s attention. There’s no debate that 0% or less on shorter maturities is unacceptable. The Fed may yet have to bring the WAM in 2021 — just for vastly different reasons than many market observers thought.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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