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The basis and balance sheet normalization

| March 15, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The Fed’s eventual unfurling of more detailed guidance on its balance sheet normalization, possibly as soon as March 20th, will likely include plans to hold its portfolio balance steady in part by reinvesting MBS principal back into Treasury debt. Although bad on the margin for portfolios overweight MBS against rates, the Fed is not the only net supplier of Treasury debt these days. The federal government is likely to issue $1 trillion or more in net new debt this year and in 2020 and 2021 and for years after that. All else equal, the flood of Treasury debt should bias all spreads tighter.

Primary dealers estimated in January that privately held net Treasury debt would rise by $1.345 trillion this year with only $286 billion coming from the Fed’s portfolio. If the Fed announces it will begin reinvesting both maturing Treasury principal and amortizing and prepaid MBS principal back into Treasury debt, the reinvestment will reduce net private supply. The absolute impact will depend on timing and the pace of MBS prepayments. Fed Treasury balances have been falling by an average of $24 billion a month and MBS by more than $16 billion. The later the Fed starts, the less impact it has.

There is a large global audience of buyers for Treasury debt, and that audience grows in proportion to US trade deficits, which the Congressional Budget Office projects at $1 trillion annually through 2021. Some of the dollars spent to import goods and services will stay outside the US and get reinvested in Treasuries. But that demand still may not be enough to absorb net private supply.

Net new supply of MBS has been running lately at an annual rate of $240 billion and, based on spreads, has been readily absorbed. A flat yield curve and low realized and implied volatility has helped build a strong bid for carry this year. MBS along with other spread products has seen good demand. The Fannie Mae 30-year par coupon yield started the year 90 bp wide of the 7.5-year Treasury curve and is now only 83 bp wide.

US deficit spending and the occasional surplus have long had an influence on fixed income spreads. When the US last reported fiscal surplus in the late 1990s and early 2000s, the resulting shortage of Treasury debt left many spreads at historic wides. Spreads on 10-year interest rate swaps, for instance, reached more than 120 bp (Exhibit 1). When recession hit in 2001 and deficit spending returned, the rising supply of Treasury debt led to tighter spreads. And since deficit spending soared to record levels in the years after the 2008 financial crisis, spreads tightened to historic levels, too. With deficits projected to exceed $1 trillion annually through 2021 and for years afterwards, spreads should steadily tighten. The Fed’s balance normalization is unlikely to stand in the way.

Exhibit 1: As US deficit spending goes, so go US fixed income spreads

Source: Federal Reserve, Bloomberg

* * *

The view in rates

The 2.58% rate on 10-year Treasury notes looks clearly rich to fundamental fair value, but it has been tracking a steady decline in rates globally. The ECB’s recent announcement of a third TLTRO, its extended guidance and its revision of inflation expectations through 2021 suggest significant weakness in Europe. Recent Fed remarks also have highlighted downside risk to growth. The 2.44% rate on 2-year notes has also started to build in slightly better odds of a Fed cut in the next two years, another signal of growth concerns. And breakeven 10-year inflation continues to hover less than 10 bp below the Fed’s 2.0% target, suggesting that most of the drop in rates has come from revised growth expectations.

The view in spreads

With the yield curve flat, rates steady, and those conditions likely to persist, carry has caught a bid. MBS could widen a little this year if new bank liquidity rules reduce bank demand for MBS. Healthy MBS net supply could also weigh on spreads. But low volatility argues for MBS, as does heavy Treasury supply. MBS should still outperform corporate credit especially as slowing growth raises concern about leveraged corporate balance sheets. Portfolios buying corporate debt should focus on names that show organic growth or use free cash flow or asset sales to pay down debt.

The view in credit fundamentals

Household balance sheets look strong, and corporate balance sheets look vulnerable. The ratio of household debt service to disposable income is at a record low, corporate leverage at a relative high. Of course, this all can continue for a long time if growth persists. The Fed has signaled that it stands ready to buffer any material softening in growth. Still, corporations may need to trim equity buybacks and reduce debt.

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