Songs for winter nights
I simply must go Baby, it's cold outside The answer is, "No" But, baby, it's cold outside The welcome has been How lucky that you dropped in So nice and warm Look out the window at that storm
This piece was prompted by recent articles by Brad Setser, Zoltan Poszar, Pippa Malgrem, myself and others – though I differ with Zoltan on CNY appreciation.
My pick for the single most significant market development of the last two years was the very large rise in global risk-free rate in 2022 and the comparatively low rise in risk-premium over the risk-free rate over the same period (with a few notable exceptions such as crypto, and JPY, briefly LDI). Yes, there was an expansion in risk premia, but falls in asset prices mostly reflected adjustment to a higher discount rate.
So, the key question now is whether a/ further rise in risk-free rate is likely and b/ can the relative stability of risk premia continue. My answer to the first question is ‘probably’ and the answer to the second question is ‘probably not’.
Photo by Conor Sheridan on Unsplash
To elaborate: 2022 saw a large US fiscal deficit (5.5% of GDP for 2022) combine with Fed’s QT plus a question mark over foreign buying. Collectively, these three effects diverted private investment from stocks / risky assets into Treasuries. As a consequence, as Bridgewater show, 2022 reported the highest purchases of Treasuries by the private sector (8.5% of GDP) outside war periods and 2010 (when unemployment was very high). Another relevant startling comparison is that the US fiscal deficit is equivalent to over 70% of global growth in 2022. These conditions will continue in 2023, though importantly yields already adjusted to private sector price clearing levels and asset prices are lower.
My explanation for the relatively low rise in risk premia is mostly due to absence of a systemic ‘liquidity event’ – something that is unlikely to be postponed forever. That said, the UK’s LDI episode was a dress rehearsal of sorts, borne out of global liquidity tightening that breached previously unknown ‘default strike’.
Foreign exchange reserve managers show no sign of returning to Treasuries, meaning for the time being the global private sector remains as the principal buyer, and yields may need to be higher to entice a switch to absorb the additional supply of Treasuries. If the US can avoid a recession risk premia find some comfort. Maybe that is what we are seeing currently.
Still, its not getting much warmer outside. I do not believe the Fed is finished with inflation fighting, which is an obvious threat to risk premia. I see Fed Funds peaking at 5.5% and remaining at that level for longer than the market expects. Furthermore, the Fed only steps in to expand its balance sheet when private sector transactions start to fail, which is usually associated with a ‘liquidity event’, the last such being the ‘dash to cash’ in March 2020. I believe there is a high likelihood of a ‘liquidity event’ at some point during the 2023, from the continued absolute decline in Fed liabilities and from the composition of those liabilities (reserves vs. RRP vs. TGA).
As a consequence:
The main risk continues to lie with Fed policy. The Fed is committed to restraining inflation and is resilient to the entreaties to pivot. I can’t believe the battle for inflation is over because although the quantity of money has slowed significantly, money velocity remains high, creating lingering upward pressure on prices. In short, the Fed is absolutely committed to killing inflation and is far from a pivot. The continued QT removes liquidity via a reduction in reserves. In addition, the composition of Fed liabilities may place pressure on liquidity. Given the unknown liquidity limits in the system, an accident is likely.
The 2023 fiscal deficit will overshoot CBO estimates, but maybe not by much. In September 2022 the Congressional Budget Office estimated the 2023 deficit will fall to 3.8% of GDP, from 4.2% in 2022. Obviously, estimates can be wrong. In 2022 the CBO estimates for both revenue and outlays was very wrong, and that may be the case for 2023 too. And note the most consequential CBO error for 2022 was a massive under-estimate of income tax receipts. The CBO also under-estimated outlays which were adversely affected by inflation and higher interest rate costs. Income tax receipts in 2023 are likely to undershoot estimates, possibly significantly. That said, the real key for 2023 deficit is probably down to changes in unemployment. Even if the US can avoid a recession, private sector demand for Treasuries will need to rise meaning upward pressure on yields. But if there is a recession, outlays will demand higher issuance plus ‘portfolio rebalance’ towards bonds will really hurt risky assets. Currently I believe the US can avoid a recession. But even so, risk is skewed to higher deficits, placing upward pressure on yields.
Demand for dollars will resume. Dollar demand ebbed significantly since beginning of Q3 2022, when global energy prices peaked. Chinese economic stimulus will create a commodity demand for dollars, plus a mercantilist need to keep CNY from appreciation. Also, the liquidity demands of US banking and securities markets will manifest in a demand for dollars. A rise in demand for the dollar increases foreign demand for Treasuries, but depresses demand for risky assets.
In summary I expect:
Resumed pressure on risky assets.
A steeper yield curve (removal of inversion). Unusually, this is likely to come from higher long-term yields, not lower short-term yields.
Jump volatility in risky assets.
A resumption of dollar appreciation.
Growing concern about private equity – think of SPACS as a visible tip of the private equity iceberg.
Peripheral problems in Eurozone require deployment of Transmission Protection Instrument (i.e. ECB does both QT and QE at the same time)
Further evident distress in Eurodollar bonds and other non-US assets dependent on US interest rates.
But you all knew that already.