If It Looks Like QE, and it Smells Like QE…

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Last Week: Interest rates fell slightly as equities extended their advance into record territory amid the official signing of the much-anticipated US-China trade deal. Hovering mere basis points above its average since July, the 10-year Treasury yield fell 2 basis points to 1.82% while 1-month LIBOR followed suit, drifting lower by three basis points to 1.65%.  Oil declined $0.50 to $58.50, as the US Dollar and Gold both strengthened. Treasury yield volatility fell to a nine-month low of 3.50.

The US-China Phase One agreement is a done deal. The deal includes a Chinese commitment to protect intellectual property rights, open up financially and buy an additional $200 billion worth of U.S. goods from four U.S. sectors over two years – on top of the baseline purchases it made in 2017. However, a significant number of existing tariffs on $360 billion of Chinese goods will remain in place – likely until after the Presidential election in November – as an enforcement mechanism.

Why you should care: The agreement marks a pause in a trade war that has rattled global markets and kept upward pressure on interest rates for two years. While the deal contains nothing that addresses structural issues in the Chinese economy, it sparked doubts about how China will fulfill its purchase commitments without significantly affecting its existing trade partners or the direction of trade flows. Full compliance with the deal would require China to increase its U.S. agricultural imports by more than two-thirds over the 2017 baseline – an unlikely event in our opinion – as doing so would compromise agricultural exports by Brazil and Argentina. It seems the US-China trade uncertainty will still haunt interest rates for quite a while longer, as US trade officials stated that any tariff reduction wouldn’t happen until after a phase-two agreement, which won’t likely start until after November’s US Presidential election.

At the end of the day, the deal at least amounts to a cease-fire in an escalating trade war in which China concentrated retaliatory fire on the American farmer. This allows both sides to claim a victory of sorts while kicking the can of tough negotiations down the road. Getting the phase one agreement across the finish line eliminates, at least for now, large, unexpected trade-driven moves in interest rates. The deal also gives President Trump a chance to trumpet a successful trade strategy during his reelection campaign, and channel the positive momentum toward phase two and other trade matters, such as a push to negotiate a trade deal with the European Union.

A Fed official acknowledged repo market interventions are partially driving stock market gains. Federal Reserve Bank of Dallas President Robert Kaplan warned that the Fed’s liquidity injections in the repo market are leading to an increase in investor risk-taking (sounds a lot like quantitative easing part 4, doesn’t it?). Kaplan said he is sympathetic to the concern that balance sheet expansion is supportive of higher equity valuations and risk assets. He cautioned that the central bank should be mindful of those concerns as it considers further action. Just when you thought you couldn’t love the Fed and its recent rate cuts more, we get this. The Fed is basically removing Treasuries from the market at the same time as adding cash, keeping short-term rates low, and its been doing it for months now. Investors have to put this cash somewhere and it is more likely to go into stocks and corporate bonds. It looks like QE, smells like QE, so therefore why is it not QE? It’s a tough one for the Fed to push back on. The trillion-dollar question now? What happens when the Fed pulls back? When the Fed begins to slow or stop this activity, as it must eventually, it will be widely seen as policy tightening, weighing on stocks and driving short-term rates higher.

The US Treasury announced a new, 20-year bond. It’s a new tool to fund the Treasury’s ballooning deficits, as investors clamor for more longer-dated, risk-free securities that offer some nominal yield, amid a global total of $11 trillion of debt with negative rates. The Treasury decision came after the U.S. reviewed other options, including ultra-long bonds maturing in 50 or 100 years. The new 20-year bond should offer notable yield premium over comparable notes abroad, presuming it slots somewhere between the current 10-year and 30-year yields, currently at about 1.81% and 2.26% respectively. Japanese 20-year bonds yield about 0.32% and German ones just 0.07%. Why you should care: The Treasury decided NOT to issue the new 20-year bonds linked to the Secured Overnight Financing Rate, or SOFR, the Fed’s preferred candidate to supplant LIBOR before 2022. Doing so would have helped speed up the transition.

What to Watch This Week:  Volatility in the US 10-year Treasury yield – the world’s borrowing benchmark – is the lowest since May, and at 1.82%, the yield is hovering very close to its six-month average of 1.77%, even after absorbing the recent flareup in Mideast tensions, the signing of a long-awaited U.S.-China trade deal, a record-setting run in stocks and confirmation that inflation remains tame amid solid economic growth.

There’s little in store this week that’s likely to change things much. The most important economic data release in the days ahead is the existing home sales report, and there are no speaking engagements from Fed officials this week. Looking out on the calendar, interest rate decisions from Japan, Canada, the euro region, the US and the U.K. near month’s end offer the only glimmer of market-moving potential, and even that is muted given that the Fed has gone out of its way to express its “on hold” stance and all but the U.K. are expected to keep rates as they are.

If you’re a fan of glitzy headlines and apparently important developments playing out on your television screen though, this is the week for you. Between the gathering of the world’s elites in Davos and the presidential impeachment trial in Congress, it’s going to be easy to make up for quiet data by watching famous (and slightly less famous) people make grandstanding speeches. The relevant question is whether the images on your screen are going to make you money. As is often the case, the answer is likely to be a resounding no.

Take-Away: The size of the Federal Reserve’s balance sheet has been a discussion among market players since the advent of large-scale asset purchases known as quantitative easing, or “QE”. Many prominent economists speculate how the massive expansion of the Fed’s reserves – the modern electronic form of printing money – and the ensuing inflation of asset prices, like stocks, would impact the economy if not curtailed in the future.

While the debate is covered extensively elsewhere, the Fed recently admitted that its involvement as liquidity provider of last resort in the repo market is indirectly driving the stock market to new record highs. As such, market analysts are increasingly labeling the Fed’s repo efforts as “QE4”, or the Fed’s unofficial 4th round of stimulus.  If the accusations are true, then the impact on interest rates will be huge, in that it puts greater pressure on the Fed to avoid rate hikes in the near term so as to avoid rattling the financial markets and in so doing, protecting the now robust spending patterns of consumers, the lone driver of US economic growth at present. Support for the Fed’s “on-hold” status is even more supported when considering that US economic growth and consumer resiliency are expected to become challenged as 2020 evolves.

Current Select Interest Rates:

 

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Source: Bloomberg Professional

10-year Treasury Yield:

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Source: Bloomberg Professional