Bond Plumbing May Be What Spurs Fed Cuts Rather Than Economy
Bond Plumbing May Be What Spurs Fed Cuts Rather Than Economy
(Bloomberg) -- The Federal Reserve should cut interest rates more quickly than the market expects, not to address U.S. economic conditions but because of looming risks to the financial plumbing, according to Credit Suisse Group AG analyst Zoltan Pozsar.
Fed funds futures are pricing in about 100 basis points of interest-rate cuts by September 2020, though three Fed policy makers -- two of whom dissented from the July 31 cut -- this week said there’s no urgency to move again. By contrast, Pozsar says the cuts are needed now to restore a positive slope to the hedging curve before the next deluge of Treasury debt issuance exacerbates stresses in the funding markets.
“I understand why they say it’s hard to justify rate cuts given the macro background, but something is going to force the Fed’s hand,” Pozsar said in a phone interview. “Things are misaligned in the plumbing, so cuts are needed.”
Specifically, the spread between foreign-exchange hedging costs and the U.S. 10-year yield has become even more inverted since turning negative in September 2018, making it more expensive for foreign investors to hold Treasuries.
As a result, U.S. dealers are left holding more bonds, which puts upward pressure on U.S. dollar-denominated funding rates, such as those for Treasury repurchase agreements that are the basis for the Fed’s Secured Overnight Financing Rate.
Ballooning Treasury supply will make matters worse. The Congressional Budget Office this week estimated the fiscal 2020 deficit will exceed $1 trillion, two years earlier than previously estimated. The $433 billion borrowing estimate for July through September, made last month, is more than double the initial estimate made in April.
The repo rate for general collateral, which has averaged about 2.20% since the Fed cut the fed funds target range to 2%-2.25% on July 31, could initially exceed the top of the range by 10 basis points to 15 basis points, Pozsar said, at which point “it’ll drag everything else with it, including the fed funds rate.”
Pozsar says things could start to get ugly as soon as early October, when investors start scrambling to secure funding for year-end.
“You have a massive supply shock made worse by the inversion, and dealer inventories are the bogey man,” Pozsar said. “Things are going to get bad before year-end.”
To contact the reporter on this story: Alexandra Harris in New York at aharris48@bloomberg.net
To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Elizabeth Stanton, Greg Chang
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