The Fed Should Stay out of the Fight for T-bills

Economic

Summary:

It should aim to match portfolio maturity to Treasury issuance.

The Federal Reserve has started its rate-cutting cycle, and Wall Street’s consensus is that quantitative tightening will end in March 2025. The Fed will then have to make the critical, if seemingly sleepy, decision on the maturity structure of its portfolio.

Before the 2008 financial crisis, bills accounted for over half the Treasury portfolio, while almost three-quarters of it matured within three years. Chris Waller – member of the Fed board of governors and a shortlist candidate to be the next Fed chair – recently gave a nostalgic speech on this front, saying: ‘I would like to see a shift in Treasury holdings toward a larger share of shorter-dated Treasury securities.’

Indeed, when the Fed in 2019 began to expand its balance sheet – not for quantitative easing reasons, but rather to simply accommodate a growing economy – its balance sheet growth came only from purchasing T-bills.

While this may seem trivial, this choice is more than just an exercise in defining the ‘neutral’ central bank portfolio. The minutes from the Fed’s November Federal Open Market Committee meeting revealed: ‘Several participants noted that leverage in the market for Treasury securities remained a risk and commented that it would be important to monitor developments regarding the market’s resilience.’

But the Fed has more responsibility than monitoring this risk. Any shift towards a bills-only portfolio would mean starving institutional cash investors of these bills and forcing them to instead provide short-term financing of the long-term Treasury securities to leveraged investors.

From the Fed balance sheet to hedge funds

The FOMC minutes also said: ‘Leverage at hedge funds remained high, partly on account of the prevalence of the Treasury cash–futures basis trade.’

The basis trade exploits the arbitrage spread between Treasury futures and cash Treasuries that are ‘deliverable’ into those futures contracts. A hedge fund goes long on the Treasury bond and short on the corresponding futures contract that is trading relatively richly – with asset managers on the other side of the futures – and collects the ‘basis’, or spread. Conservatively estimated, the basis captures 45 basis points annualised, which hedge funds leverage at least 20x in repurchase agreements or prime brokerage for upwards of 9% annualised return.

The Treasury Borrowing Advisory Committee – a group of market participants that advises the Treasury – said that 20x is ‘anecdotally’ a good approximation basis trade leverage. An article from Fed researchers Ayelen Banegas and Phillip Monin reported that hedge funds were averaging 56x leverage on Treasury repo borrowing.

The trade is not actually risk-free; it is particularly risky when there is a ‘dash for cash’ and the basis diverges. Most infamously, when the pandemic struck the economy, rates were headed lower for longer, so futures prices rose, but cash Treasuries nonetheless sold off as investors sought cash.

The true size of the trade is also unknown, but current indicators suggest it’s bigger than its pre-pandemic peak. Earlier this month, the Financial Stability Oversight Council reported: ‘As of September 2024, leveraged funds’ net short Treasury futures contracts had a notional value of $1.1 trillion, nearly double the peak observed in the leadup to the COVID-19 pandemic.’

What does the basis trade have to do with the Fed’s portfolio choices? Well, in the limited history of QT we have, it seems the basis trade machine goes into overdrive when the Fed puts duration back on the market.

QT and the hedge fund basis trade: a symbiotic relationship

The Treasury greatly expanded its issuance duration in both QE eras. It increased the weighted-average maturity of outstanding Treasury debt to 70 months during the post-2008 financial crisis QE, from 55 months previously; WAM rose to 75 months amid pandemic-era QE (Figure 1).

Figure 1. Weighted average maturity of marketable debt outstanding

The Fed Should Stay out of the Fight for T-bills_1

Source: US Treasury

These increases petered out or fell once the Fed stopped bond purchases and began QT. During these QT episodes, when the Fed was pushing the Treasury’s new duration onto private markets, the hedge fund basis trade appears to have done a lot of the heavy lifting. After the 2008 financial crisis, the Fed started shedding bonds in October 2017; after the pandemic, QT began in June 2022. Both of those dates look like inflection points on the various size proxies of the hedge fund basis trades (Figures 2 and 3).

Figure 2. Hedge fund net short positioning in Treasury futures has increased further as asset manager net long positions have continued to grow

Aggregate net positioning across US Treasury futures, $bn

The Fed Should Stay out of the Fight for T-bills_2

Source: Financial Stability Oversight Council

Figure 3. Hedge fund net repo positioning

Source: Jonathan Glicoes, Benjamin Iorio, Phillip Monin, and Lubomir Petrasek (Federal Reserve Board)Note: Net repo is defined as the total repo positions minus reverse repo positions held by qualifying hedge funds that report on SEC Form PF.

Hedge funds’ manufacturing floors

Of course, there’s nothing inherently bad about hedge funds taking maturity transformation risk and getting paid for bearing it. But it’s worth zooming out to inspect what kind of maturity transformation we’re asking of them here – and if it’s worth running blowup risk of the basis trade, or if there’s a better way.

In the basis trade, hedge funds are taking long-term Treasuries and using them to manufacture different Treasury instruments: short-term, Treasury-backed repos that can then be held by the ultimate source of funds – institutional cash piles. From an institutional cash management perspective, a Treasury-bond backed repo is wholly dominated by a Treasury bill. There is no counterparty risk, no duration risk in the collateral, no risk of needing to take possession of an asset the liquidity pool is not allowed to own.

The Treasury is thus missing an opportunity to issue substantially more bills, the size of which can at least be proxied by the basis trade. Indeed, such issuance would crowd out the trade. Yet, Treasury secretary-nominee Scott Bessent wrote in the Wall Street Journal that the Treasury’s recent inching toward shorter-term issuance ‘has distorted Treasury markets’, suggesting he’ll seek to term out Treasury issuance.

As such, it is particularly incumbent on the Fed to avoid further exacerbating the problem by reallocating to bills or focusing exclusively on bills when organic balance sheet growth resumes. That’s not to suggest it would be appropriate for the Fed to exclusively buy duration, as that would look and feel like monetary financing.

The Fed’s portfolio should, however, use a strategy it has used in small doses in the past: it should aim to match its portfolio maturity to that of oustanding Treasury debt. This avoids incentivising the issuance of any particular duration, and it avoids the net negative outcome for financial stability of exacerbating the bill shortage.

Source:teven Kelly

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Warren Takunda

Cryptocurrency

Bitcoin hodlers should start selling BTC “aggressively” once realized profits reach a key milestone, analysis says.

In one of its Quicktake blog posts on Dec. 13, onchain analytics platform CryptoQuant told readers to watch the portion of the Bitcoin supply “in loss.”

BTC supply in loss can drop 50% before sell signal

Bitcoin bull markets have a habit of ending when supply profitability crosses a certain threshold, CryptoQuant said.

Reviewing the last bull market, which reversed in late 2021, contributor Onchain Edge said that supply profitability signals were in place for many months.

“When the BTC supply loss % goes below 4% you should start dcaing aggressively out of BTC and wait for the next bear market lows,” according to accompanying commentary.

Onchain Edge was referring to an investment technique called dollar-cost averaging (DCA) — the practice of buying BTC with a set amount of another asset, such as fiat currency, at regular intervals.

To avoid the volatility and subsequent comedown that characterized much of 2021 and to protect profits, February was arguably the time to begin selling BTC via DCA, reducing exposure.

“Why? Below 4% means a lot of people are in a profit this is the peak bullrun phase,” the post continued.

An illustrative chart showed daily moving averages of the current percentage of supply at a loss, which as of Dec. 12 was still circling 8%. Bitcoin Analysis: Start Selling BTC When This Key Metric Hits 4%_1

Bitcoin Analysis: Start Selling BTC When This Key Metric Hits 4%_1

BTC/USD chart with supply loss data (screenshot). Source: CryptoQuant

Bitcoin whale profits still modest

As Cointelegraph reported, other market participants are watching profitability levels of certain hodler cohorts for BTC price cues.

In particular, the round numbers $110,000 and $120,000 are upside targets, thanks to the effect that crossing them will have on short-term holders (STHs).

These speculative investors tend to react more suddenly to BTC price moves.

Analyzing unrealized profits among Bitcoin whales, meanwhile, fellow CryptoQuant contributor Darkfost saw little cause for concern.

“If we compare to what happened in March, the unrealized profit ratio almost reached 2 before declining as whales began to take profits and Bitcoin’s price started to fall,” another Quicktake post explained.

“With the unrealized profit ratio currently around 1.2 and Bitcoin priced near 100k, this indicates that there may still be room for the bullish trend to continue in the mid-term.” Bitcoin Analysis: Start Selling BTC When This Key Metric Hits 4%_2

Bitcoin Analysis: Start Selling BTC When This Key Metric Hits 4%_2

Bitcoin whale unrealized profit ratio (screenshot). Source: CryptoQuant

Source: Cointelegraph

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Owen Li

Central Bank

Economic

Non-manufacturers also remained upbeat on business conditions, though concerns over rising raw material and labour costs weighed on retailers' morale, the survey showed.

The data released ahead of the Bank of Japan's two-day policy meeting next week highlights how an intensifying labour shortage is becoming a headache for companies and a potential constraint to economic growth.

Companies expect business conditions to worsen over the next three months, the BOJ's "tankan" survey showed, as soft global demand and threats of higher tariffs from US president-elect Donald Trump cloud the outlook.

The headline index measuring big manufacturers' business confidence stood at +14 in December, up from +13 three months ago and marking the highest reading since March 2022, the survey showed. It compared with a median market forecast for +12.

The improvement was due largely to a rebound in auto production and robust demand for equipment as companies ramp up capital expenditure, a BOJ official told a briefing.

"Companies seem to be weathering headwinds from China's economic weakness. This is good news for the BOJ and shows things are on track for the economy and prices," said Saisuke Sakai, chief economist at Mizuho Research & Technologies.

An index gauging big manufacturers' sentiment declined slightly to +33 from +34 in September, compared with a median market forecast for a reading of +32.

The business mood worsened sharply among retailers, hotels and restaurants as they struggled to hire staff, and faced rising labour and raw material costs, the survey showed.

"Demand from inbound tourism remains strong but may be peaking, while households may be becoming more frugal," said Kazutaka Maeda, an economist at Meiji Yasuda Research Institute.

Big companies expect to increase capital expenditure by 11.3 per cent in the fiscal year ending in March, higher than a 10.6 per cent gain projected in the previous survey in September. The increase was bigger than market forecasts for a 9.6 per cent rise.

Small non-manufacturers' sentiment improved to levels last seen in 1991 as the pass-through of rising costs lifted profits, the survey showed, a sign Japan is seeing signs of sustained price rises - a prerequisite the BOJ set for further rate hikes.

Companies expect inflation to stay above the BOJ's 2 per cent target one, three and five years ahead, the tankan showed, suggesting that conditions for raising Japan's still-low interest rates were falling into place.

But companies expect conditions to worsen in the three months ahead as they face stubbornly high costs, slowing overseas growth and uncertainty over Trump's policies.

"The outlook is highly uncertain due partly to Trump's tariff policies, which could weigh on automakers' profits," said Sakai at Mizuho Research & Technologies.

"Non-manufacturers are also cautious about the outlook as they feel the pinch from labour shortages. The outlook for consumption is also weak due to prolonged price rises," he added.

The BOJ ended negative interest rates in March and raised its short-term policy rate to 0.25 per cent in July on the view Japan was making steady progress towards sustainably achieving its 2 per cent inflation target.

BOJ Governor Kazuo Ueda has said the central bank will continue to raise rates if companies keep hiking prices and wages due to optimism over the outlook, and help keep inflation durably around its 2 per cent target.

Sources have told Reuters the BOJ is leaning toward keeping interest rates steady next week as policymakers prefer to spend more time scrutinising overseas risks, though there is no consensus on the final decision.

The tankan's sentiment diffusion indexes are derived by subtracting the number of respondents who say conditions are poor from those who say they are good. A positive reading means optimists outnumber pessimists.

Source: Reuters

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ING

Economic

The UK economy has been on quite the journey this year, at least if the GDP figures are to be believed. Having started the year with an eyewatering – and indeed eyebrow-raising – 0.7% quarterly growth figure for 1Q, momentum has slowed considerably in the second half of the year. October’s monthly GDP saw activity fall for the second consecutive month, albeit only by a marginal 0.1%. Overall fourth-quarter GDP is likely to be flat, we think.

In reality, the story is more nuanced than that. Much of that early 2024 strength was concentrated in sectors that are less tangible and typically not consumer-facing. Service sectors with a clear consumer focus and more intrinsically linked to underlying economic fundamentals actually performed more strongly over the summer when the broader economy appeared to be slowing – albeit we did see a sizable drop in activity in these areas during October.

Our conclusion from this is that the economy has probably slowed down, but neither the initial boost nor the more recent sluggishness is likely to have been as extreme as this year's monthly GDP data indicates.

Consumer-facing services saw activity plunge in October

UK Economic Momentum Slows Further but Budget Boost is Coming_1

All of this of course is history anyway. We still think that the UK economy is poised to outpace most of Western Europe next year, judging by our 2025 annual GDP forecasts. That perhaps says more about the health of other parts of the continent, but it also heavily reflects the recent fiscal stimulus.

Public spending was increased by some £60bn – or more than 2% of GDP – relative to budget plans inherited from the previous Conservative government. Some of that might not materialise and we’re sceptical that the planned, sudden increase in public investment can readily find its way into shovel-ready projects straight away. But the majority of the spending increase is going to government departments in day-to-day funds, much of which will end up in wages. And thus the fiscal multiplier – or the passthrough to wider economic growth – is likely to be pretty high.

Having said all of that, the risks are clearly tilted downwards. The UK is often singled out as being less affected by an impending US trade war, and that is true. But America still buys 20% of UK exports, even if the majority of that is in services which are not impacted by tariffs.

Then there’s the jobs market. The official data is of dubious quality right now. But a range of indicators suggest hiring appetite has cooled materially this year and payroll-based data suggests that employment, outside of government-heavy sectors, has fallen by almost 1% since the end of 2023. We suspect this gradual cooling will continue into 2025, and risks being amplified by recent tax hikes on employers. Around half of Chief Financial Officers who responded to a recent Bank of England survey suggested they’d deal with those tax rises by reducing employee numbers.

However, unless growth materially disappoints, and that’s not our base case, the Bank of England is going to remain laser-focused on inflation. With services inflation stuck around 5%, next week’s meeting is likely to be a bit of a non-event, with policymakers opting to keep rates on hold again until February.

Source:ING

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Risk Warnings and Disclaimers

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Warren Takunda

Economic

Britain’s economy shrank by 0.1% in October, underlining the scale of Labour’s challenge to get the economy growing.

Figures from the Office for National Statistics showed the unexpected fall in GDP was driven by declines in construction and production, while the dominant services sector stagnated.

Economists, polled by Reuters, had expected the economy to grow by 0.1%. It follows a decline of 0.1% in September and sluggish growth of 0.1% in the third quarter of the year, according to figures last month.

Keir Starmer said last week it was the government’s “aim” to make the UK the fastest-growing G7 economy, while pledging to deliver higher real household disposable income by 2029.

However, a range of companies have said they plan to slow spending and hiring after Labour’s budget in October, which included £40bn of tax rises.

Economists said the second successive monthly contraction in GDP meant the economy had grown for only one of the five months to October, and might mean the economy shrank for the fourth quarter as a whole.

The chancellor, Rachel Reeves, said the figures were “disappointing” but insisted Labour was putting the economy back on track for growth.

“While the figures this month are disappointing, we have put in place policies to deliver long-term economic growth,” said Reeves. “We are determined to deliver economic growth as higher growth means increased living standards for everyone, everywhere.”

Business groups have complained that measures announced in the budget, including an increase in employer national insurance contributions, add to their costs and deter investment.

Production output fell by 0.6% in October because of falls in manufacturing, mining and quarrying, while construction fell by 0.4%.

“The economy contracted slightly in October, with services showing no growth overall and production and construction both falling,” said Liz McKeown, the director of economic statistics at the ONS.

“Oil and gas extraction, pubs and restaurants and retail all had weak months, partially offset by growth in telecoms, logistics and legal firms.”

Paul Dales, the chief UK economist at Capital Economics, said it was “hard to tell how much of the fall is temporary as activity was put on hold ahead of the budget”.

“The clear risk is that more activity was cancelled or postponed after the budget,” he said, citing weak PMI data. “There is every chance that the economy went backwards in the fourth quarter as a whole.”

Figures last week showed that growth in the UK’s dominant services sector slowed to its lowest rate in more than a year in November as firms digested business tax rises in the budget.

The closely watched S&P Global UK services PMI survey scored 50.8 in November, slowing from 52.0 in October.

The pound fell to its lowest level against the US dollar in nearly two weeks, dropping as much as 0.4% in early trading.

Analysts said the contraction in the UK economy could make it more likely that the Bank of England monetary policy committee will vote to cut the base rate when they meet later this month.

“These latest figures will send a chill through the corridors of Westminster, as the government’s growth agenda looks increasingly at risk,” said Isaac Stell, investment manager at Wealth Club.

“With more and more companies stating they will cut back on hiring and investment to deal with the rising costs related to the budget, the question will be, where will growth actually come from?”

The disappointing growth figures came as a survey by GfK showed that consumer confidence remained suppressed in December amid the “continuing uncharitable view on the UK’s general economic situation”.

The market research company’s latest consumer confidence survey said that consumers “don’t know where they are going” and are still thinking twice about big-ticket purchases.

Anna Leach, the chief economist at the Institute of Director, said: “As we head further into the festive season, and consumer confidence remains in the doldrums, many businesses are continuing the process of updating their business plans for the coming year to accommodate significant increases in employment costs.

“The recent blows to businesses have made the task of achieving stronger sustainable growth harder.”

Separate ONS trade data showed imports and exports of goods fell in October. Exports to the European Union were higher than exports to the rest of the world for the first time in nearly a year.

“A weakening export climate amid rising global policy uncertainties and declining business confidence, exacerbated by the impact of recently announced budget measures, raises concerns about sustaining the growth momentum,” Hailey Low, associate economist at NIESR, said.

Last month, the Bank trimmed its annual growth forecast for 2024 to 1% from 1.25% but predicted a stronger 2025 with 1.5% growth, reflecting a short-term boost to the economy from the budget.

Source: TheGuardian

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Devin

Central Bank

The PBOC will “step up expectation management on exchange rates and vigorously respond to external shocks,” the head of the monetary policy department Zou Lan told state media in an interview. In addition, the central bank will “resolutely prevent risks of overshooting in the exchange rate.”

The PBOC’s new “moderately loose” monetary policy has increased its ability to respond to growth challenges, Zou said, days after the bank unveiled the new stance and a day after the government said the monetary authority would look to loosen policy in the near future to support the economy.

No details were announced on the possible timing of further monetary easing, but the statement also repeated the usual pledge to keep the yuan “basically stable,” likely signaling the central bank will make an effort to slow depreciation of the Chinese currency as it loosens monetary policy.

Pressure on the yuan has intensified since the re-election of Donald Trump, who has threatened to impose tariffs on China and other countries. Some investors have speculated Beijing will abandon its current policy of maintaining a stable currency to compensate for any impact this could have on its economy.

The yuan has fallen sharply since mid-October and slid Thursday after a media report that the authorities were considering letting it depreciate in response to the threat of a trade war with the US. The onshore yuan lost 0.1% to 7.2795 against the dollar on Friday, with its offshore peer down 0.2%.

Source:Bloomberg News

Risk Warnings and Disclaimers

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Warren Takunda

Economic

The pound fell on Friday after data showed the British economy shrank unexpectedly in October, which could prompt traders to attach a greater chance to the prospect of speedier rate cuts by the Bank of England next year.

Official data showed UK economic activity contracted 0.1% in October. A Reuters poll of economists had forecast a rise of 0.1% last month, from September's 0.1% fall.

This was the first back-to-back decline since the onset of the COVID-19 pandemic in 2020, when Britain imposed the first lockdown.

Sterling initially fell as much as 0.43% after the numbers and was last down 0.3% at $1.2635.

"The market will be surprised, this is not part of the game plan. However, the outlook for 2025 does look more encouraging," Neil Jones, managing director, FX sales and trading for financial institutions, TJM Europe, said.

"I would expect further limits to any pound sell-off and gilt rally. Wages and inflation will likely remain solid and dissuade the BOE from shifting lower, relative to the Fed and ECB expectations," he said.

The pound was last down 0.4% against the euro at 82.895. Sterling is set for a second monthly gain against the euro, which has fallen 0.6% in December so far to trade around its weakest in over eight years.

In part, it is the expected difference in interest rates in Britain and the euro zone, as the BoE is likely to move more slowly on cuts than the European Central Bank.

The ECB cut rates as expected by a quarter point on Thursday, but sounded a cautious note on the outlook for inflation, which might mean it does not have the scope to deliver the almost five cuts markets have priced in for 2025.

The Dow and S&P 500 each lost more than half a percent, and the Nasdaq shed more than six tenths of a percent to dip back below 20,000, a milestone it crossed a day earlier.

The BoE, meanwhile, may find it needs to act more swiftly to head off a more protracted slowdown in the British economy.

Recent data on business activity showed a deterioration in the manufacturing sector. Grocery inflation is creeping up, squeezing the budgets of British households, while the labour market is sputtering.

Data earlier this week showed job vacancies have dried up faster in the UK than in other similar countries over the past year.

A separate report on employment on Dec. 9 showed demand for UK workers crashed in November, after the Labour government's first budget, in a sign of the impact of the tax increases for employers that it contains.