The Federal Reserve’s pending tapering of its gargantuan bond purchases hasn’t registered much in the markets. Nor has the end of another gimmick involving the government’s on-hand cash.
But these developments should rivet investors’ attention, warns Joseph Lavorgna, chief economist for the Americas at Natixis. Bond investors may end up getting hosed.
“Government debt dynamics are going to be less bond friendly in the months ahead,” Lavorgna wrote in a note. Expect a “negative financial market reaction.”
Fed Chair Jerome Powell has indicated that, likely by year-end, the central bank will start its taper, shrinking the $120 billion-per-month purchase list for Treasury bonds ($80 billion) and agency mortgage-backed securities, or MBS ($40 billion). Most analysts believe that means the purchase program will end next summer.
Up to now, Fed demand for Treasury paper—57% of all issuance over the past year, by Lavorgna’s count—and the Treasury Department’s cash hoard have buffered investors from some harsh fixed-income realities, in the economist’s view. Soon, though, the bond market will have to go cold turkey, as those palliatives disappear.
The government would have had to borrow far more if it didn’t have the ready cash to fall back on, Lavorgna explained. Over the past 12 months, Washington ran a $2.9 trillion budget deficit. Nonetheless, marketable Treasury issuance grew just $1.7 trillion. The difference was that the government drew on its cash fund. As a result, the cash balance fell to $0.5 trillion as of July from $1.8 trillion. And at this point, according to Lavorgna, the government can’t raid the cash drawer anymore, because it needs the money to pay Uncle Sam’s bills, bridging the gap between tax collections and obligations due.
“The impact on the bond market will be much larger than the numbers imply,” Lavorgna said. The government needs to borrow $2.2 trillion over the next 12 months, and without its reliable fallbacks, he expects the Biden administration will make a nasty splash in the fixed-income world. Unable to dip into cash and without the Fed as a ready buyer, the burgeoning Treasury security issuance ahead means bond prices will fall. And interest rates will rise. That’s not a good prospect for bond investors, not to mention consumers.
“Bond bulls have been forewarned,” Lavorgna declared.