How the Treasury refresh may not be catastrophic

Posted by Cam Hui -

Preface: Explaining our market timing models

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

 

 

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

 

 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities (Last changed from “buy” on 26-Mar-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 17-Mar-2023)
  • Trading model: Bearish (Last changed from “neutral” on 02-Jun-2023)

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.

 

 

A liquidity catastrophe?

Even before the resolution of the debt ceiling impasse, analysts had been warning about the consequences of a post-deal hangover.
 

 

It was said that the U.S. Treasury market would see a flood of new issuance which would draw liquidity from the financial system. Such a loss of liquidity would create significant headwinds for the prices of risk assets. Since the conclusion of the debt ceiling deal, the warnings have become a cacophony. Estimates vary, but consensus market expectations call for the issuance of about $1 trillion in Treasury paper over the next three months.
 


 

I have warned before about the liquidity impact of new Treasury issuance and I am certainly cognizant of the risks. However, there is a narrow path for a benign resolution of the reset of the U.S. Treasury’s cash balances without significantly affecting the price of risk assets.

 

 

A financial plumbing primer

There are three main ways to affect U.S. financial system liquidity. The first is changes in the Fed’s balance sheet, which is slowly falling because of the steady pace of quantitative tightening. The second is changes in the Treasury General Account (TGA), which is the U.S. Treasury’s “bank account” held at the Fed. As the debt ceiling approached, Treasury took extraordinary steps to avoid default by drawing down TGA balances, which injected liquidity into the banking system by spending the cash. The third is the Reverse Repurchase Agreement operations (RRP), which the New York Fed describes in the following way:
The Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York (New York Fed) is responsible for conducting open market operations under the authorization and direction of the Federal Open Market Committee (FOMC).

 

A reverse repurchase agreement conducted by the Desk, also called a “reverse repo” or “RRP,” is a transaction in which the Desk sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the transaction.
Most RRP transactions are overnight RRPs (ON RRP). The Richmond Fed explained the reasoning behind the RRP facility this way:

The Federal Reserve’s Overnight Reverse Repo (ON RRP) facility provides a floor to implement its interest rate target (i.e., the federal funds rate) in abundant reserve environments. (For an explanation of repo markets, see the 2020 article, The Repo Market Is Changing (and What Is a Repo, Anyway?)

The idea is that the ON RRP facility gives participants in the short-term funding market the risk-free overnight option of lending to the Fed at the guaranteed ON RRP rate. Thus, other lending rates — like the fed funds rate — will be above the ON RRP rate.1 Figure 1 illustrates how the short-term funding network functions in the U.S.

 

 

A funny thing happened to RRP balances as they exploded in March 2021:

In the original design, ON RRP was a backstop, as market participants should lend to banks or others (via federal funds, repo, wholesale deposits, commercial papers, etc.) before lending to the Fed.2. This was the case during the early stage of the pandemic: The daily usage of ON RRP averaged $8.7 billion from March 2020 to March 2021.

 

However, ON RRP usage steadily increased after March 2021 and reached an unprecedented $1.6 trillion in September 2021. This hints at an excess supply of nonbank savings that is not intermediated by banks or absorbed by Treasuries, which has ultimately flowed into the ON RRP facility. The Fed becoming the borrower-of-last-resort has prompted concerns about how the U.S. banking system is functioning during the pandemic. Concerns include, for example, bank capital regulation being too tight or the Fed’s actions creating asset dislocation.

At about the same time, TGA balances (blue line) fell dramatically, though that’s not the only reason for the surge in RRP levels (red line). The Richmond Fed offered the factors as reasons why RRP rose so dramatically:

  1. The escalated supply of funds due to the saving glut in the shadow banking sector.
  2. The reduction in the supply of Treasury bills (due to TGA drawdown) that used to absorb non-bank savings.
  3. The dislocation and uptake of banks’ balance sheet capacity due to quantitative easing.
  4. The reduction in banks’ ability to expand balance sheets due to capital regulation.
  5. The reduction in the profit margin of banks’ intermediation due to the interest rate policy.

 

 

Here is how the TGA account reset could be relatively benign for risk assets. Even though TGA is expected to rise by about $1 trillion over the next three months, RRP balances are well above that level. What’s not known is how much of the funds invested in the RRP facility would migrate over to Treasury’s new issuance. A shift from RRP to TGA would have no liquidity effect, whereas a direct investment into Treasury paper from other funding sources would draw liquidity from the U.S. financial system.

 

That’s the narrow path to a benign outcome. At this point in time, we have no way of knowing how much RRP balances will flow into new Treasury paper. Equity bulls and bears will be waiting with bated breath for the results.

 

Keep an eye on the spread between the Treasury Bill rate and the RRP rate, which is currently pegged at 5.05% to maintain a floor on the Fed Funds rate. While the spread is positive right now, which may  incentivize institutions to park their funds in Treasury Bills, the RRP rate will have to rise by 25 basis point in lockstep with the Fed Funds target should the Fed raise rates at either the June or July FOMC meeting.

 

 

June swoon still in play

Turning to the technical conditions of the stock market, conditions are setting up for a pause and pullback and a June swoon scenario is still in play.
From a technical perspective, the S&P 500 is testing overhead resistance while the NYSE McClellan Oscillator reached an overbought condition and pulled back.
 

 

 

There has been much discussion about the poor breadth exhibited by the market. Here is a glass=half-full and half-empty analysis. Notwithstanding the minor 5-day RSI divergence, the S&P 500 is testing the highs set last August. Note the breadth readings in the three indicators in the bottom three panels. In two of the three, namely percentage of S&P 500 bullish on P&F and percentage of the S&P 500 above their 50 dma, current readings are lower than they were in August and those two indicators are showing signs of deterioration. On the other hand, the the percentage of S&P 500 above their 200 dma is higher today than the August reading, though that indicator peaked in February and it is also deteriorating. I interpret these conditions as long-term constructive for stock prices, but as a sign of short-term caution.
 

 

Sentiment readings are turning giddy. The weekly AAII bull-bear spread has reached levels similar to readings achieved just before the market top in late 2021. While sentiment can’t be described as euphoric, current conditions call for a measure of caution.
 

 

Similarly, the CBOE put/call ratio has fallen to levels consistent with complacent conditions based on recent readings. Longer term, however, they have only normalized to pre-pandemic levels. I interpret these conditions as the market needs a pullback and consolidation, but they don’t forecast a crash.
 

 

Last week’s market stall saw a surge in the small-cap Russell 2000. Sentiment has become so frothy that the Russell 2000 ETF (IWM) call volumes spiked to an off-the-charts level.
 

 

 

Putting it all together, current technical and sentiment conditions indicate that near term risk and reward is tilted to the downside. The magnitude of the pullback may be a function of how much of the funds from the RRP facility flows into TGA without affecting overall financial system liquidity. The coming week will see a crucial U.S. CPI report and interest rate decisions from the ECB, the Fed, and the BoJ, which could be sources of volatility.

 

My inner investor remains neutrally positioned. My inner trader is short the S&P 500. The usual disclaimers apply to my trading positions:

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account.  Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

 

 

Disclaimer: Long SPXU

 

6 thoughts on “How the Treasury refresh may not be catastrophic”

  1. The TGA business is well anticipated, so there should be no surprise. Surprises catch people off guard.
    But if there is a surprise hidden in this TGA refilling then prices could drop..
    Before we had computers and internet, what did banks do? Why this complicated process? Why can’t banks just hold their money? To me it is symptomatic of an unhealthy banking system.
    Abandoning mark to market is not healthy but is being done more often. Was it ever done before the GFC?
    AI apparently consumes a lot of energy, reminiscent of cryptos and their bubble.
    Maybe we end up chopping along between 3500 and 4300 for what will seem like forever. But since the drunken sailors have a free credit card until Jan 2025 maybe we get more spending in an attempt by both sides to harness votes, which would be bullish.

  2. This week has monthly and quarterly options exp. A lot of in the money call options are out there. Basically it is people buying call options and dealers doing covered call hedging, and the cycle feeding and reinforcing itself. Very likely we will see a short-term retreat in a lot of names already way up there.

    Going forward, the recession probability is receding and vix is stuck below 15. The market will be grinding higher ever so slowly and lots of systematic flows will re-leverage. It is early in a bull market. Small/mid caps are lagging big caps by a very large margin. Past instances will have small caps leading already but due to the recent banking crisis they are lagging. Rotation from big caps to small caps will lift small banks and algos will interpret this is confirmation of early stages of bull markets. So far CRE has not manifest as a big problem. So likely there is a slow process in resolving the issues.

    Back to earnings front, AI has caused a lot of investment houses to revaluate stock markets, upward. One report I have seen is making a case for Nvidia to reach 3T market cap. Sound outrageous. But the more I crunch the numbers and factor in the synergetic forces all coming together at the same time and it just looks likely. Sure it could fall apart. But it just indicates that more work to be done and we will be back. It is inevitable. One report I read proposes an application of mRNA and self amino acid modification/substitution in proteins together as a fundamental tool in fighting all kinds of diseases. Everything we see today is all likely to be totally subverted tomorrow. Changes are that fast. A lot of techies who made a lot of money the last 20 years are into all these activities which have never been seen in human history. The scale is unfathomable. One breakthrough and it quickly creates a large industry and generates tons of money and accelerate the overall knowledge base and level. In turn even more money are fed back into the process. Your head will not be spinning fast enough to capture a glimpse. Among all these there will be at least one Dr. Evil who emerges, and no gov is powerful enough to fight him/her/it.

  3. Remember that Wall Street speaks out of both sides of the mouth.
    I’m not convinced about the market makers hedging….let’s call it a partial truth in that there is some hedging, so we have a misdirection.
    Consider that dealer buys to cover a hedge, consider the possibilities.
    First if the options do not expire in the money, what does the dealer do? Sell the underlying or redo writing calls? Neither would perpetuate a rise.
    Second, if they are in the money do they get delivered or does the buyer sell the option before expiration? If they get delivered, what does the buyer do with them? If they get sold, what does the dealer do? Rewrite them?
    So the net result is nothing much unless you have an ever increasing volume (open interest) of calls.
    But we get the impression of an irresistible force.
    The siren call of endlessly increasing profits is not a new one.
    Maybe we are in a global debt crisis which will be resolved by universal money printing, in which case the purchasing power of currencies may drop precipitously, in which case the market is undervalued in terms of future currencies, but the cynic in me would expect one plunge to flush out longs before that would happen. Unless that was the Covid plunge.
    We’ve never had helicopter money before, we have had fiat for 50+ years, but for most of those debt was manageable, is it manageable now?
    Market cap is set by the last price and shares outstanding, but to sell, you need a buyer. If the gov’t is not printing it, then it comes from either more borrowing from banks or selling something to raise the cash.
    Maybe I’m too old school, but I don’t trust this rally.

    1. On the other hand, Paris-based Unibail-Rodamco-Westfield this week announced its withdrawal from operating the Westfield Mall in downtown San Francisco. An earlier statement explains their rationale, which I certainly agree with:

      “A growing number of retailers and businesses are leaving the area due to the unsafe conditions for customers, retailers, and employees, coupled with the fact that these significant issues are preventing an economic recovery of the area,” Westfield and Unibail-Rodamco-Westfield wrote in a statement at the time. “URW has actively engaged with City leaders for many years to express our serious concerns, which are shared by our customers and retailers. We have urged the City to find solutions to the key issues and lack of enforcement against rampant criminal activity. The current environment is not sustainable for the community, or businesses, and we are hopeful the City will implement the changes that are so urgently needed.”

      1. Sounds bullish huh?
        That’s how insane the bad news is good news story is…so will prices go up? For malls in SF….it shows how deranged the market is…but as they say “you play with the cards you are dealt”

Comments are closed.