Friday, February 18, 2022

Unexpectedly Large Treasury Surplus in January Is Creating Stress In the Markets

Most people generally accept and understand that the Fed executes its monetary policy operations through the FOMC by purchasing or selling US Treasury securities and, in doing so, adding or removing reserves from the banking system. It isn’t controversial or insightful to say that an increase in the supply of reserves causes rates to come down, and vice versa when supply decreases. Per the Fed’s website:

“To raise the FFR, the Fed decreases the supply of reserves by selling U.S. Treasury securities in the open market. The decrease in reserves shifts the supply curve left, resulting in a higher FFR.

To lower the FFR, the Fed increases the supply of reserves by buying U.S. Treasury securities in the open market. The increase in reserves shifts the supply curve right, resulting in a lower FFR.”

However, what most people do not understand and/or acknowledge is that US budget deficits (i.e. Treasury cash outlays exceed inflows) are achieved by the Fed adding reserves to the banking system, and budget surpluses (i.e. Treasury cash inflows exceed outlays) are done by the Fed removing reserves. A 2018 paper released by the Chicago Fed makes this explicitly clear:

“When the U.S. government makes a payment, funds are withdrawn from the TGA [Treasury General Account] and sent to the bank accounts of individuals or businesses. These transfers increase the reserves of the commercial banks that hold the private accounts. Similarly, when the government receives a payment, the source of the payment is an individual or business account at a commercial bank and, ultimately, the reserves of the commercial bank.”

Orthodox economics tells us that a government which runs chronic budget deficits will eventually be forced by the bond market to pay higher interest rates as punishment for “profligate spending.” One of the critical insights of MMT is that, by looking at the order of operations of our monetary system, this “bond market vigilante” theory is complete nonsense. Per the above, budget deficits increase the supply of reserves in the banking system, and increasing the supply of reserves in the banking system leads to lower rates.

This is overwhelmingly supported by empirical evidence. Consider Japan. Like the US, the Japanese government issues debt in its own currency, and has been running large fiscal deficits for the last 30 years. Over that time, the interest rate on the 10yr JGB has gone from 5% to basically 0%:

Same goes in the US. Aside from a short period in the late 1990s/early 2000s, the US has been consistently running budget deficits for the last 30 years. As MMT would predict, rates have been falling over that same period:

Notice, too, how a recession followed shortly after fiscal year 2001 budget surplus. When the US government runs a budget surplus, that leads to the Fed removing reserves from the banking system. It is a de facto rate-hike, and takes away financial resources from the non-government sector. The weakened financial position increases the likelihood of a recession.

I bring this up because the BLS recently released the January budget figures, and it turns out the US government ran a budget surplus of $119 billion, the first since September 2019 ($83 billion), and an unusually high amount for the month of January. Market participants might recall the big Repo market blow-up that took place in September 2019, where stress in overnight funding markets caused the Secured Overnight Financing Rate to spike unexpectedly:

As the Fed explains, this was basically a timing issue: there was an insufficient supply of bank reserves due to higher-than-expected tax collections by the Treasury on September 16, which coincided with a $54 billion Treasury debt sale settlement, both of which caused a rapid $120 billion decline in bank reserves. This brought the aggregate level of reserves down to its lowest level since 2012. The lack of reserves increased bank borrowing needs, which spooked lenders (mainly Federal Home Loan Banks or FHLBs) and caused them to pull back on collateralized loan advances.

Let me repeat: insufficient reserves caused overnight rates to spike. That is precisely what MMT predicts! More reserves lead to lower rates, less reserves lead to higher rates. Given that fiscal deficits add reserves, that means that fiscal deficits lead to lower interest rates, and surpluses lead to higher rates. This stands in direct contrast to the mainstream view that fiscal deficits will (eventually) lead to higher rates. It’s all a gigantic lie/myth/fraud, perpetuated for decades by Wall Street, the media, policymakers, and academics.

So what happened in January 2022 when the Treasury ran a budget surplus, removing reserves from the banking system? Exactly what we would expect to happened: rates rose! This past January saw the largest fiscal surplus ever for the month of January. Lo and behold, the rates on US Treasury securities exploded. The secondary market rate on the 3 month US T-bill went up by 4x in a month, from 6bp to 24bp:

This unexpected event caused funding stress in money markets (as evidenced by the rapid rise in rates) which subsequently caused a decline in the stock market, as leveraged traders (read: HFs) had their margin loans called by banks and were forced to de-gross their portfolios. As a result, the NASDAQ had its second worst January performance ever (January 2008 was the worst) and the S&P 500 and Dow Jones Indices each had their worst overall monthly performances since the pandemic-induced panic in March 2020.

But not all stocks were treated equal over this period. “Growth” funds got absolutely slaughtered: Whale Rock Capital lost 15.9%, Tiger Global lost 14.8%, and Melvin Capital and Light Street Capital each lost 15%. Meanwhile, so-called “value” stocks performed exceptionally well. In fact, quant fund giant AQR’s value fund posted its best month ever this past January. The media has dubbed this the “great rotation” into value stocks. While I would love to see a secular rotation into value stocks, I am skeptical of this explanation. The more rational reason for this performance discrepancy is that for years, by far the most consensus trade for HFs has been “long growth, short value.” So, as reserves were transferred out of the banking system, margin lenders were forced to call in their loans, forcing HFs to de-gross their portfolios. By de-grossing, they sold their “growth” stock longs and covered their “value” stock shorts. And given that all these HFs have piled into the same names, there is very little liquidity from buyers. We are routinely seeing companies report earnings after hours and immediately go down by double-digits. As mentioned in a prior post, Meta Platforms (formerly Facebook) set a record for largest market cap loss in a single day.

This sequence of events is shockingly similar to what happened in September 2019. As mentioned before, September 2019 was the last month that the Treasury ran a budget surplus, causing stress in overnight funding markets. I distinctly remember that period because in the span of a few days, the portfolio of stocks I was helping manage at the time had the most ridiculous three-day stretch of performance I’ve ever seen, returning ~15%, including 7% on a single day. I remember chatting with friends in the industry who said many people’s portfolios were blown up from this, just like they are today. The move was so swift and severe that the media started writing about the beginning of a great “rotation” out of growth into value. You can’t make this stuff up. Rinse, cycle, repeat.

There are other examples of stress occurring in the markets today. We already wrote about the yield curve flattening/inverting, and how the mortgage market is expected to slow down dramatically compared to the last two years. Clearly, that is a sign that demand for mortgages is slowing. And yet, mortgage rates have experienced the largest monthly jump in 9 years. If mortgage rates are spiking, that is a sign that lenders are nervous about underwriting new loans. Think of a mortgage rate spike like the yield on a corporate bond: if yields explode, that is a sign of stress in the markets. Under healthy financial conditions, lenders feel confident and compete with each other, causing rates to go down. When they become nervous, they either pull back on their lending activities (leading to less competition) or demand higher rates to compensate for the perceived risks. High rates are an indication of fewer suppliers of credit, assuming demand is flat. But we know for a fact that demand is actually down, based on the outlook for mortgage originators like LDI. If demand was down but financial conditions were strong, lenders would be forced to lower their rates. The fact that demand is down and yet rates are spiking is a bad sign.

It is insane that nobody on Wall Street or the media connects the dots between the Treasury running a budget surplus causing stress in the markets. January 2022 and September 2019 share striking similarities. All the pundits insist the recent rapid rise in rates is because of the market’s perception that the Fed will adopt a more hawkish stance and hike rates multiple times in 2022 in order to “fight inflation” (I used quotation marks because, as argued previously, the notion that rate hikes slow inflation is questionable at best). And as a reminder, nobody updates their DCF model with a higher discount rate because the yield on the 10yr went from 1.5% to 1.8%. This is all just a narrative created by the media and Wall Street. In reality, the jump in yields is due to reserves being removed from the banking system thanks to the Treasury’s unexpectedly large budget surplus. Treasury flows affect real economic outcomes. Perhaps there is some marginal impact by speculative macro hedge funds laying on curve steepener trades. Indeed, after failed iterations of this trade in 2021 caused huge losses at big macro HFs, they have once again been piling on the steepeners in 2022:

And yet the results have been the same.

The fact that Wall Street and the media sticks to these false narratives just shows they have no idea what they’re talking about. When one understands the monetary operations of our financial system, it is easy to connect the dots between the Treasury running a budget surplus, removing reserves in the banking system, causing yields to spike, stress in funding markets, and forcing leveraged traders who have piled into the same trades to de-gross their portfolios. Using an MMT lens allows us to better see and understand this happening in real-time.

As for trade ideas to take advantage of these conditions, I have been adding the long-bond to my personal account. Treasuries have gotten hammered recently, so they offer higher yields. Their special legal status as HQLA means there will always be a bid for them when markets become stressed. Opportunities are created when changes in price are inconsistent with their fundamentals, which is exactly what’s happened. Additionally, the Treasury has gone back to running a deficit in February, and I expect that to continue until taxes are collected in April. Deficits add reserves, so we should expect rates to come down. Investors also might want to consider looking at Virtu Financial (VIRT), who is a specialist market-maker in equities and derivatives. When markets become stressed, volatility goes up and trading spreads widen, which are a benefit to VIRT’s bottom line. The VIX is up +72% YTD:

At 9x LTM P/E, VIRT looks reasonably priced (albeit not "pound-the-table-cheap") if the volatility continues.

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