A tinker, not a taper

The question above seems straightforward, with a straightforward answer. The first quarter of 2021 was the fifth-worst quarter for US Treasury securities in the past three decades, as 10-year yields rose by nearly 90 basis points.

Every financial journalist and market commentator under the sun is now talking about a “rising interest rate environment” and what that means for other asset prices.

But, but, but … did you know that US money-market rates have just fallen to all-time lows?

The world’s most important number

Before it became a dirty word, LIBOR was often referred to as the “world’s most important number”. According to estimates put together by the Bank for International Settlements, a mind-boggling $150 trillion of derivative contracts continue to trade off US dollar LIBOR.

Yet whilst government bond yields have spiked, the world’s most important number has been drifting ever closer to zero.

That seems a symptom of a super-abundance of cash looking for a home in short-dated securities. The Federal Reserve is hosing the financial system with money and there simply isn’t enough short-dated government debt to go around.

Other symptoms of this imbalance include overnight repo rates dropping to just one basis point, and three-month Treasury-bill yields flirting with zero. Lend to the US government for the next year, and you will receive the princely sum of three basis points in return.

A backstop facility provided by the Federal Reserve for money-market funds to park cash at zero basis points has seen usage skyrocket in the past two months. Appetite has been so brisk that the New York Fed has been forced to increase its counterparty limits and list of eligible counterparties in recent months.

Dollars and duration

So what? Does any of this matter for assets outside the money-market space? I can think of two implications.

First, everyone keeps on telling me it is irrelevant for the US dollar, but I can’t help but make the observation that the dollar’s been weak at the same time as the short end of the yield curve has collapsed from March this year onwards. The rates payable on emerging currencies have started to drift higher. The Bank of England’s Jan Vlieghe signalled a possible rate hike in the UK as early as May next year. We had a similar nod and a wink from New Zealand last week. As long as the Federal Reserve refuses to even “think about think about” raising rates, it’s hard to see the dollar trend turn around.

Second, we’ve seen general collateral and triparty repo rates nailed to the floor in recent months, down from +10 basis points at the end of last year. That’s not a huge change, but makes it that little bit cheaper to fund long-duration positions and/or more expensive to fund short-duration positions. We are tactically short duration, but the emphasis is on tactically given the carry costs (which are getting steadily worse) and positioning.

To ‘fix’ the problem, we expect the Federal Reserve to push up its administered rates at the next opportunity in June. Precedent for the central bank tinkering with the Interest On Excess Reserves (IOER) came in both June 2018 and January 2020.

The trick this time will be to persuade the markets, and those members of the public paying any attention, that this adjustment is not a tightening of monetary policy. A tinker, not a taper, will be the order of the day.