Next week we’ll have one of the more defining FOMC meetings of recent memory. In preparation for the meeting, we’ll dive into the treasury markets again, and the confounding factors that make accurately pricing debt extremely difficult in the short to mid-term.
Table of Contents
Valuing Short-Term Debt
Funds Flow out of The RRP
Long Dated Treasuries
The Yield Curve Normalizing?
Forecasting the FOMC
A New Speaker of the House
Conclusion
Internal References
1. Valuing Short-Term Debt
If you’ve been subscribed from the beginning, you are well aware that this substack has primarily been centered around the treasury markets and how they impact the broader risk markets.
Over the last bit of the current cycle (2022-2023), we saw the short-dated debt invert and present higher yields than the long-dated side of treasuries. This was the yield curve inversion that occurred and remained in place for the entirety of the time that the Federal Reserve began and continued Quantitative tightening.
As previously discussed, this was due to the US government financing more of its debt on the short end of the curve rather than the long end, meaning that the Fed’s QE interventions were more active on the short end of the curve than the long end. This meant that ending QE and reversing into QT would have a disproportionate impact on the short end of the curve.
We saw that impact materialize and remain in the form of an inverted yield curve, which was extended and lasted for a significant amount of time as was predicted here. However, there is another aspect of this that we must discuss, and I’ll have to get a bit personal in order to discuss it.
So… at the start of June, I made a bet for 1 ETH back when we were still waiting for the Senate to pass the recent debt ceiling bill. This was a bet with an acquaintance of mine who runs a private capital investment advisory in Puerto Rico/Texas. They have been around for 2 decades now, and obviously, I have to be mindful of my limitations and use the time I have speaking with him to gain valuable insight and mentorship.
I am mostly self-taught, and that comes with a lot of upsides and downsides. When you read my thoughts, you should be mindful of the Pros and Cons of my informal experience and be sure to pay attention to other sources with more formal education and formal experience to get a well-rounded outlook.
As an example, most self-taught people do not know what they don’t know because they missed out on the benefits that a mentor can provide. Knowing the limits of your knowledge is crucial. There are certain lessons that you can only learn by making a horrible mistake, or being told about it by someone else who has. Most self-taught people are always on the edge of disaster because they have only had success and have not yet had the kind of mistake that can end them entirely.
However, I just could not help myself at all. So the bet that we made (on May 31st) was about the interest rate of the 30-day treasury at the close of the day on August 1st. I presumed that the rate of this treasury would be above 6% by that day, while he believed it would be lower than that.
As you can see in the chart above, I lost that bet. The blue vertical dashed line is the start of the bet, and the red vertical dashed line is the end of the bet. My acquaintance had expected short-term yields to fall significantly, while I had expected them to keep rising, what they actually did was more or less hold flat against the Overnight Rate + 0.05%.
If you’ve been reading me for a while you probably know what my logic was in making the bet, after the debt ceiling bill passed, treasury demand would not be able to keep up with the increased treasury sale volume.
His thesis and my ultimate loss helped me learn something valuable that ties together some of what we already know.
His thesis was that in the face of the government shutdown, funds deployed in money market funds could no longer be invested in US treasuries, and that shortfall in demand was what had pushed short-term interest rates so high above the overnight rate. But once the government shutdown was temporarily averted, these money market funds could now invest in short-term treasuries. If you are unfamiliar, Money Market funds can only invest in a narrow group of assets. US Government treasuries with a duration of 90 days or less are considered to be “as good as cash” and are one of these assets money markets can invest in. While a potential government shutdown is on the table, money market funds cannot invest in treasuries due to the implied default risk, regardless of whether a default would ever happen (it won’t).
While the uncertainty of a government shutdown loomed, the highest yield that money market funds could reliably invest in was in the Overnight Reverse Repo Market (RRP). Which you’ll remember pays the Overnight lending rate + 0.05%.
Money Market Funds, among many others, have been parking money in the RRP for yield, and you’ll recall that we have mentioned before that the liquidity in the RRP can be considered to be dry-powder that can be “withdrawn” to buy government treasuries. Previously I had mentioned the Fed cutting the rate offered at the RRP as a means to pull liquidity, but this liquidity also gets pulled when short-term treasuries offer higher rates than the RRP.
Funds Flow out of the RRP
That is exactly what is happening now, and it’s why I lost the bet.
Now that US treasuries are considered “safe” for money market funds to invest in again, we’ve seen the shorter end of the yield curve hit a wall right at the Overnight lending rate +0.05%. Anytime it goes higher than that amount, it is profitable for a money market fund to shift funds out of the RRP and into short-term treasuries.
You’ll note that the date of the bet was essentially the high water mark. In the time since that bet the RRP has been drawn down from $2.2 trillion to a little over $1.0 trillion today. If this continues (which it will) at this rate (debatable), the RRP will be totally withdrawn by ~February of next year.
It’s a lesson well learned, I regret that it cost me 1 ETH, but such is life.
If the RRP does get fully drawn down and there is still a larger supply of cyclical debt that needs to be purchased, then we will likely see short-term treasury rates push far higher than the overnight lending rate. Of course, if the US House of Representatives can’t select a speaker of the House before November 17th, the government will shut down again as they will need to authorize a spending bill by then to keep the government open. As of the time of this writing, no speaker has been selected. (this changes, I cover the speaker in Section 5).
As I said above, despite being an expensive lesson, it was a lesson well learned.
I’m very happy to have people like this in my life who are willing to entertain my thoughts and ideas while providing me with some guidance and mentorship on the subject. You do not need to go to college for a subject, nor do you need to be certified by some outside entity. But at the same time, if you are going to be self-taught, you absolutely owe it to yourself to interact with and learn from as many people as you can who have been in the trenches on whatever subject you wish to become an expert at.
Everybody has limitations, and the style and form of your education will define the types of limitations you have. While being self-taught allows you to think in fluid ways and approach old problems with fresh ideas, it also makes you vulnerable to the exact type of thing I discussed in my “Mindfulness of Limitations” section that I quoted above. People with more formal learning might fail to see the things that their sector typically fails to see, but they also come with the internalized knowledge of centuries of hard-fought wisdom that has been passed on in formal education.
You don’t need a formal education, but you absolutely have to be aware of the benefits it can provide before you eschew it, otherwise, you’ll have a huge blindspot.
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