U.S. government shutdown risks now shift to Feb 8
Debt limit concerns approach with March X-date
Treasury auctions 2-year T-notes as yield rises to a 9-1/2 year high
BOJ expected to leave policy unchanged but is coming under pressure to consider QE exit strategies
U.S. government shutdown risks now shift to Feb 8 — The U.S. government shutdown ended on Monday after Congress approved a new continuing resolution lasting until February 8. However, there is now the risk of another shutdown in just 2-1/2 weeks when the new CR expires.
In fact, there will be an ongoing threat of a U.S. government shutdown until Congress finally approves a spending bill for the remainder of the fiscal year and stops lurching from one CR to another. The CRs simply give Washington the opportunity to use a CR for leverage for a variety of issues including DACA, higher defense spending, a border wall, etc.
The markets on Monday showed little reaction to the shutdown drama since the shutdown was expected to be short lived and have little macroeconomic effect. However, the markets will be much more concerned if Washington starts playing politics with the debt ceiling, which brings in the much more serious issue of a Treasury default.
Debt limit concerns approach with March X-date — The Treasury is already using emergency measures to stay under the debt ceiling that was reinstated on Dec 8, 2017. The Bipartisan Policy Center estimates that the X-day for a debt ceiling hike will come some time in March, which is only five weeks away. There has been no move in Congress as yet to address the debt ceiling since Congress in late 2017 was preoccupied with the tax-cut bill and is now bogged down with a spending bill and immigration issues.
The T-bill market has already been distorted by the outside possibility that the Treasury might default on the payment of principal or interest in March. However, the pricing on the U.S. 5-year credit default swap remains subdued, illustrating that there is little real concern at present about a Treasury default. In fact, the 5-year credit default swap price, which represents the cost of insuring against a U.S. sovereign default, fell to a 1-1/2 year low of 19.2 bp on Monday.
Treasury auctions 2-year T-notes as yield rises to a 9-1/2 year high — The Treasury today will sell $26 billion of 2-year T-notes. The Treasury will then continue this week’s $103 billion T-note package by selling $15 billion of 2-year floating-rate notes and $34 billion of 5-year T-notes on Wednesday, and $28 billion of 7-year T-notes on Thursday.
Today’s 2-year T-note issue was trading at 2.08% in when-issued trading late yesterday afternoon. That translates to an inflation-adjusted yield of 0.27% against the current 2-year breakeven inflation expectations rate of 1.81%.
The 2-year T-note yield has risen sharply by about +80 bp in the past four months and posted a new 9-1/2 year high on Monday of 2.07%, the highest level since late 2008. That sharp rise in the 2-year T-note yield has made the 2-year T-note more attractive to investors with a higher coupon yield. However, the 2-year T-note yield is likely to continue rising through 2018 as the Fed progressively raises its funds rate target, meaning investors will have some capital losses on their 2-year T-note if they want to sell it before maturity.
The 12-auction averages for the 2-year are as follows: 2.28 bid cover ratio, $156 million in non-competitive bids to mostly retail investors, 4.4 bp tail to the median yield, 21.7 bp tail to the low yield, and 51% taken at the high yield. The 2-year is the least popular coupon security among foreign investors and central banks. Indirect bidders, a proxy for foreign buyers, have taken an average of only 50.3% of the last twelve 2-year T-note auctions, well below the average of 63.2% for all recent Treasury coupon auctions.
BOJ expected to leave policy unchanged but is coming under pressure to consider QE exit strategies — The market consensus is that the Bank of Japan at its Monday/Tuesday policy meeting will leave its monetary policy unchanged. The BOJ is currently following a yield-curve control policy of targeting the 10-year JGB yield near zero, with an apparent target range around zero of plus/minus 0.1%. The BOJ seems to be willing to allow the size of its annual 80 trillion yen QE program to fluctuate in size under its primary goal of managing the 10-year JGB yield.
The BOJ two weeks ago announced that it was slightly trimming its longer-term bond purchases. That announcement did not represent an official cut in the size of the BOJ’s QE program but did acknowledge that the BOJ no longer needs to buy as many bonds to manage interest rates since there are so few bonds left in the hands of private investors after the BOJ has absorbed so many with its massive QE program. Even so, the smaller bond purchases were a sign of things to come as the BOJ comes under pressure to start considering how it will wind down its QE program.
The 10-year JGB yield in the past two months has risen by about 4 bp to 0.076% mainly because of upward pressure from the rise in U.S. and European bond yields. If the 10-year JGB yield continues to rise and challenges the perceived 0.1% upper limit of the BOJ’s target range, the markets will be watching to see how aggressively the BOJ defends that 0.1% level. If the BOJ makes only a half-hearted effort and the 10-year JGB yield moves above 0.1% on a sustained basis, then the BOJ will be under pressure to allow its JGB yield target to move higher, thus representing a slight tightening of monetary policy.
However, Japan’s inflation rate is still very low at 0.6% y/y and the BOJ is not ready to let up on its aggressive monetary policy. The markets are not expecting the BOJ to start raising short-term benchmark rates until 2019 at the earliest.