Quarterly Outlook
Macro Outlook: The US rate cut cycle has begun
Peter Garnry
Chief Investment Strategist
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Prepare for a liquidity squeeze and higher US Treasury yields
Althea Spinozzi
Head of Fixed Income Strategy
Summary: We believe that volatility in US rates is far from over. Once Congress passes the debt ceiling bill, the US Treasury must issue large amounts of bonds, particularly by the end of June. That, together with Quantitative Tightening (QT) and an RRP rate of 5.05%, translates to high T-bills yields for longer and a further bear flattening of the yield curve.
Even if the debt ceiling agreement passes Congress this week, removing the tail risk of a US default, the outlook for short-term US Treasuries remains bleak. Indeed, while the Federal Reserve decides whether to increase interest rates, the US Treasury needs to rebuild the Treasury General Account by issuing large amounts of new debt.
Responsible for liquidity in markets are: (1) the Fed's balance sheet, (2) the Reverse Repurchase Facility, and (3) the Treasury General Account.
Despite the Fed letting $95 billion run off every month in an attempt to tighten the economy, the Treasury has spent $500 billion since February to support continuous operations. That resulted in liquidity being supported while the RRP facility remained stable.
However, things are about to change. Around $1 trillion of bills needs to be issued before the end of the year, and about half of those will need to be issued by the end of June. That would add further pressure to continuous Quantitative Tightening (QT) operations, draining liquidity suddenly.
The question is whether the market will be able to absorb all that new supply. As per Goldman Sachs, banks' reserves have some buffer to take down some of this supply, but it will not be enough to take it all. Therefore, money market funds, which have a bit over $2 billion in the Fed's Reverse Repurchase Facility (RRP) at 5.05%, will need to absorb the new bills. The caveat is that T-Bills must cheapen enough to offer a pickup over the RRP.
Therefore, yields will continue to soar in the near term and remain elevated. Yet, a liquidity squeeze will be a massive drag to the economy and will likely limit the selloff in long-term rates unless the Treasury decides to increase the new long-term notes issuance.
What are the key levels we should look out for?
2-year US Treasury yields (2YYM3): they are likely to break above 4.63% and rise to test strong resistance at 4.80%. To break above the latter might be more challenging, and we will need to see bets of a June rate hike escalate for yields to attempt soaring toward 5%.
10-year US Treasury yields (10YM3): yields are likely to soar towards 3.91% but at a slower pace than short-term yields. As it becomes clear that the liquidity drain becomes a drag on the economy, yields will begin to revert.
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