The Market's Want PALM but The Fed/Treasury "Puts" Are Not Struck Here
Live shot below of investors searching for the level of the Fed & Treasury “put” strike prices to save them from a risk asset price correction.
Investors, aka petulant children, are always looking for help from the Fed and/or Treasury to provide more liquidity to assist their investments in a world that needs “number go up” no matter what. I have affectionately referred to this as begging for PALM, the Perpetually Accelerating Liquidity Machine.
However, given data that still shows labor market strength with firmer Employment Cost Index yesterday throwing caution on the idea that wage inflation is consistent with returning inflation to target while overall inflation remains well above 2% and has been re-accelerating over the last 3 months, the Fed is simply not in position to provide accommodation for the market at this time.
As we push out the timeline before Fed liquidity additions, the risk asset markets won’t like it. The strike price on the Fed “put” is lower. The Fed will need to see a significant deterioration in the labor market from here in order to start easing. Right now, there is very limited evidence that the labor market is slowing like that.
With the Fed removing rate cuts, and pushing out the timeline to provide liquidity, markets have to shift their focus to finding where the Treasury will execute their “put” and provide with the PALM they so desire. Given the passive way the Fed has conducted QT (stupidly i might add, big mistake, has made their job harder), they have shifted over part of their monetary policy toolkit to the Treasury who can influence markets by deciding where on the curve it wants to issue Treasury securities.
We know that with fiscal deficits elevated for as far as the eye can see (Govt Spending “Put” always activated), Treasury has a lot of debt to sell but demand for the debt is different at various points of the duration curve.
Broadly speaking, the more Treasury issues at the front of the curve where demand is robust and the less they issue at the back where demand is more suspect at current yields, Treasury can provide “liquidity” as there is lower risk premium associated with the short end of the curve for investors and the private sector isn’t being asked to lend the government as much money for longer periods where risk premiums are higher.
Even though term premiums (extra compensation investors demand for lending long term) are very muted vs historical averages, which means Treasury should be trying to lend further out in time and lengthening its maturities, Treasury can and has often decided to borrow more shorter term in recent years, particularly after periods of yields/volatility/term premiums rising so as not to create a larger risk asset sell off. This happened most recently in October 2023 and there were expectations this would happen again this week with its QRA announcement. The market was thinking the Treasury “put” was struck here.
However, what we learned on Monday afternoon and again confirmed this morning, is that the Treasury “put” could not be struck here. With tax receipts coming in lighter than expected and spending needs continuing to accelerate, overall borrowing needs are once again coming in higher than originally believed.. This means Treasury has to maintain an elevated duration issuance calendar for at least another 3 months while raising end of 3q cash levels at the TGA makes it more difficult for them to add liquidity to the economy and markets over the next several months into the election.
With overall bond volatility still muted vs recent QT-era range and term premiums on the low side vs history as well, Treasury simply couldn’t offer the markets the liquidity they wanted at this point. The Treasury “put” strike price is lower too.
With both Fed and Treasury “puts” lower than here, I think we are in for a rough trading period over next few weeks as markets rapidly re-price lower in order to find where those “puts” are actually struck.
