One of the most important things to understand about Bond Markets is that the day to day movements have surprisingly little to do with the fundamentals that the financial economists spend the whole day talking about. Mostly they reflect the putting on and the unwinding of massive leveraged trades that, while broadly linked to the fundamentals, are driven far more by what we refer to as the ‘market mechanics’. Thus, to take an example of last week’s sharp sell off in US Treasuries, while the talk was all about a new inflation/reflation trade causing a sell off at the long end, the reality was that the action all took place around the 5year Bond area, which had its worst day since 2002. The lack of cover in a new Treasury auction, reflecting something of a buyers’ strike, itself a reflection of uncertainty over some regulatory positions for banks going forward, was an initial shock to the system, but was heightened by the realisation that, in a $21trn market for US Treasuries, liquidity all but disappeared at exactly the point it was needed. As a series of stop losses were triggered the technical aspects dominated, meaning that far from bonds selling off because expectations on inflation changed, they sold off most heavily where people already had an inflation trade in place! Nothing then to do with inflation. It’s always wise to remember that nothing is black and white in markets.

The TGA Unwind – Yellen retains her importance.

The irony is that there is, potentially, another huge near term technical issue hanging over the US Treasury Market, which is the exact opposite of last week’s problem of a lack of liquidity; it is the risk of a sudden flood of liquidity into the short end of the market, which, left unchecked, could drive short rates below zero. The reason is the Roadmap that new Treasury Secretary Janet Yellen has set out for the unwind of a little-known item called the Treasury General Account or TGA. Just as Janet Yellen was important when she was at the Fed and they were in charge of markets via monetary policy, so she is, if anything, even more important now that she is at the Treasury with the ability and intention to unwind $1.6trn of liquidity into markets. Indeed the shift from Monetary to Fiscal dominance is the regime change we are now all seeing.

Briefly, the TGA is rather like a current (checking) account for the US government and historically it sat around zero. More recently however this has grown into a positive account in the hundreds of billions as the Treasury borrowed the money but didn’t spend it. Back in early 2017, then President Trump and his Treasury Secretary Steve Mnuchin inherited a TGA of $400bn or so and promptly ran it down to zero, the liquidity injection into markets doubtless helping drive ‘risk assets’ higher. Subsequent to that however, they built the TGA up again such that Biden and Yellen have now got a pot of $1.6trn that has been borrowed, but not spent. Yellen has said that she plans to inject half of it ($800bn) back into the market over the next two months and ultimately get it back to $500bn by June. That is of course a phenomenal amount of liquidity to digest and the risk is that it drives short rates below zero – something the Fed does not want, raising the seemingly bizarre prospect of the Fed raising rates on overnight deposits in order to control the front end of the yield curve.

Equity investors have long grown used to the periodic hits to equities as leveraged bond traders seek easy liquidity, which is why we class bond markets as the biggest near term risk for equities at the moment and an understanding of these mechanics may help anticipate where the hits are coming from. The Bond economists are naturally calling for a resumption of Operation Twist – essentially the Fed aiming to flatten the yield curve by selling/pegging the short end and buying long bonds – in order to keep bonds out of a bear market. But this raises the question of whether the politicians will let this happen. After all, the point of fixed income from the borrower’s point of view is that the coupon is fixed, the change in the calculated yield is merely a reflection of the capital gain/loss to the end investor. They can continue to fund at the short end. Perhaps they are finally prepared to let the long end rise to something approaching ‘normal’?

If that is the case then we could see a very steep yield curve indeed, which from an efficient allocation of capital perspective would be very healthy as long term investors could finally secure something approaching a positive real yield even if they had to mark some losses on existing portfolios, something which would of course be rather uncomfortable for Bond managers and their clients. Even now they are trying to find ways to redefine equity risk to allow them to buy equity instead. It would naturally also be very bad for all the structured products repackaging capital gains as income, but that’s a subject for another day.

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