Inflation tax
August 8, 2021 – Weekly Comment
Senator Joe Manchin sent a letter to Chairman Powell on Thursday, August 5. Here are the key lines:
“…I am increasingly alarmed that the Fed continues to inject record amounts of stimulus into our economy by continuing an emergency level of quantitative easing…” And, “I am deeply concerned that the continuing stimulus put forth by the Fed, and proposal for additional fiscal stimulus, will lead to our economy overheating and to unavoidable inflation taxes that hard working Americans cannot afford.”
What’s the significance of the Manchin letter? One interpretation might be that if a Senator has finally identified the problem that it is probably close to over. Could it be an attempt to shift more responsibility onto the Fed and away from elected politicians? Re-imposing Covid mask rules regardless of vaccination status is already sitting uneasily on the populace. I think the articulation of inflation as a tax might be the key takeaway that resonates with the population at large. The fact that used car prices may level off in support of the transitory argument will have little impact on a larger change in inflation perceptions. When inflation is loosely equated with wage gains, as it has been by the Fed, it’s an acceptable goal. When inflation is framed by a top politician as a tax causing a decline in living standards when there is already pervasive discussion of wealth inequality, it becomes a problem.
Over time, I have never really thought that changes in treasury supply correlated well to rates. When things are going badly in the economy, rates go down, and this is often accompanied by greater treasury supply as government spends more for unemployment etc. When things are great, there might be less treasury supply as tax revenues increase. Less supply might be thought of as supporting higher, not lower rates. However, for the sake of the tapering discussion, let’s talk a little bit about supply and demand. The below excerpt is from the Treasury Borrowing Advisory Committee (TBAC) recommendation to Sec’y Yellen dated August 3, 2021.
Given the current fiscal and economic outlook, the Committee strongly supports coupon reductions beginning at the November refunding. The Committee estimates that beginning the adjustment in November rather than waiting until the February 2022 refunding results in about a $350 billion reduction in the amount of coupon debt outstanding, allowing the Treasury to maintain more T-bill supply for a given amount of coupon cuts. For November, the Committee recommends reductions of 2-, 3-, and 5-year securities by $2 billion per month. The Committee also recommends reductions of the 10-year security by $3 billion, and the 30-year security by $2 billion for both new issues and reopenings in the quarter. For 7-year and 20-year securities, the Committee recommends declines of $3 billion and $4 billion, respectively, which are somewhat larger than the declines in surrounding securities. It was expected that, based on current fiscal and economic projections, these cuts would need to be sustained over a few quarters in order to maintain T-bills in the recommended range of 15 to 20% of total debt outstanding over time.
This amounts to a reduction in treasury supply of $18 billion per month starting in November. The Fed is buying $80 billion per month in treasuries. Apart from the implications of a broader shift in policy, a taper announcement should be easily absorbed with reduced purchases offset by lower supply. Additionally, as mentioned by Guy Lebas in a twitter thread, the creation of a Standing Repo Facility reduces risk of foreign CBs to own treasuries. “These CBs use USD for managing FX fluctuations, but now with SRF, they need less cash, can own treasuries, clip the coupon and freely convert to USD via the Fed efficiently.”
We’re now three weeks away from Jackson Hole when some believe Powell could lay the foundation for a specific taper announcement. The next payroll report comes the following week, on Sept 3. The next FOMC is September 22. CPI on Wednesday and PPI Thursday. Another strong payroll report should easily clear the way for tapering to begin at the September meeting, especially if other data remain solid. The BOE was hawkish last week, and this weekend, ECB’s Weidmann warned on inflation. “We have to make it clear again and again that we will tighten monetary policy if the price outlook calls for it.” Treasury auctions of $58 billion 3’s, $41B 10’s and $27B 30’s.
OTHER MARKET THOUGHTS/TRADES
Hawkish comments by Clarida last week were punctuated by a strong employment report on Friday, causing the market to freshly evaluate both the timing of the taper and the onset of a move away from funding rates near zero percent. On the week, the green Eurodollar pack (3rd year) was the weakest part of the curve, falling 9.125 bps. Reds (2nd year) fell 6.75 bps and blues (4th) fell 7.5. The five year note rose 6.4 on the week to 0.764% and tens up 5.4 bps to 1.288%.
Many contracts put in outside range weeks and closed near the lows, including FVU, TYU, EDZ2, EDZ3, EDZ4. Five month highs were posted on the weaker than expected ADP release on Wednesday morning, followed by a sharp end-of-week sell off. As an example, EDZ3 ticked a high of 9923.0 on Wednesday and a low of 9898.5 on Friday, a range of nearly ¼%, closing at 9900.5. This type of formation across many contracts signals a trend change, where rallies should now be sold.
In terms of calendar spreads, the highest one-year calendar settlement over the cycle has been EDM23/EDM24 which peaked at settle of 78 on April 5. Currently, that calendar is 48.0 and the peak on the curve is has moved forward to EDU22/EDU23 at 59.5 as the market has somewhat moved the tightening schedule up even as the magnitude of potential hikes has (for now) declined.
| 7/30/2021 | 8/6/2021 | chg | ||
| UST 2Y | 18.6 | 20.6 | 2.0 | |
| UST 5Y | 70.0 | 76.4 | 6.4 | |
| UST 10Y | 123.4 | 128.8 | 5.4 | w/I 131.2 |
| UST 30Y | 189.4 | 193.4 | 4.0 | w/I 194.7 |
| GERM 2Y | -76.2 | -75.6 | 0.6 | |
| GERM 10Y | -46.1 | -45.6 | 0.5 | |
| JPN 30Y | 63.5 | 63.6 | 0.1 | |
| CHINA 10Y | 285.5 | 281.5 | -4.0 | |
| EURO$ Z1/Z2 | 22.5 | 28.0 | 5.5 | |
| EURO$ Z2/Z3 | 50.5 | 54.0 | 3.5 | |
| EURO$ Z3/Z4 | 35.5 | 34.5 | -1.0 | |
| EUR | 118.69 | 117.64 | -1.05 | |
| CRUDE (active) | 73.95 | 68.28 | -5.67 | |
| SPX | 4395.26 | 4436.52 | 41.26 | 0.9% |
| VIX | 18.24 | 16.15 | -2.09 | |
https://www.cnn.com/2021/08/06/business/inflation-fed-manchin/index.html
https://home.treasury.gov/news/press-releases/jy0308
https://home.treasury.gov/system/files/221/TBACRecommendedFinancingTableQ42021-08042021.pdf
