Rates Spark: Fed In The Driver’s Seat

Hopes of further Fed stimulus are keeping the long-end supported. A deal on a US stimulus package would remove a tail risk. The Fed's balance sheet shows Wall Street standing up to the crisis, but Main street still in pain. The main impulse against this backdrop remains one biased towards lower long rates, flatter curves, and big negative real rates.

Source: Fed, ING

Fed's balance sheet steady, with Wall street support still on the decline

The balance sheet of the Federal Reserve is holding in the USD 7trn area - moderately higher from last week, but not significantly so. That is still up some USD 3trn from where it was before Covid-19 took hold. The breakout shows ongoing buying of Treasuries and Mortgage Back Securities, balanced by a reduction in use of foreign central bank swap lines. There was also a reduction in the use of the commercial paper funding facility, and a reduction in use of the money market liquidity facility.

Buying corporate credit also slowed, again. The latest week showed buying at a pace of a little under USD 125m per day, or USD 615m over the full week. This is the slowest pace of purchases since the programme began. No surprise here, as Fed insiders had intimated a couple of weeks back that the programme could potentially be wound down to zero should the functioning of credit markets continue to show a positive dynamic. This, together with the primary market element, are programmes that never really had to be bigged up.

The New York Fed announced yesterday it is looking to widen the eligibility criteria for some of its market facilities: the Commercial Paper Funding Facility (CPFF), the Secondary Market Corporate Credit Facility (SMCCF), and the Term Asset-Backed Securities Loan Facility (TALF). We doubt this will have a material effect on the Fed's balance sheet in the near term but it is a welcome precaution should they become necessary again.

In terms of help for Main Street, the paycheck protection programme is holding in the USD 68bn area. There was a moderate rise for the latest week, but not a significant one. There was also a small build in the Main Street lending programme, but again the rise in use of this newer programme has not been significant. This is not necessarily good news, as less use of these programmes keeps the pain elevated, rather than resolved.

The main market impulse against that backdrop remains biased towards lower long end rates and a flatter curve. The fact that the 10yr real yield is homing in on -100bp is another important guidepost that the rates market is far from pricing in the "V" that equities are seeing.

Stimulus hopes

USTs should remain in the driver's seat into at least until next week’s Fed meeting, and until a stimulus package is approved by Congress. On the former, hopes of an increase in the duration of QE purchases continue to help our USD-EUR rates tightening view. Logically, the long-end performed best, and helped duration on the EUR curve too. We see less of a case for the EUR long-end to flatten, as it seems to us the part of the curve most likely to reflect the rise in issuance comes September.

The $1tr stimulus package being discussed is maybe not as generous as the previous iterations, but it would have the benefit of avoiding a cliff-edge effect with support payments to the unemployed drying out. In effect, a deal would remove a tail risk for rates markets, and hand the Fed the initiative in dictating direction. The strength of price action so far this week means the Fed would have to acknowledge it is seriously considering the idea of extending duration of QE purchases to avoid any disappointment.

There is a dearth of market drivers on this side of the Atlantic, save perhaps for July European PMIs released this morning. As most indices are expected to return above 50, it cannot be excluded that they boost sentiment temporarily. With hopes of further monetary stimulus alive and well, good economic data can be a double-edged sword, however.