My Name is Bond, Janet Bond
Now that the US debt ceiling crisis, which was both serious and silly, has joined Y2K as the latest disaster that never actually happened, the US Treasury, led by Janet Yellen, is focused on replenishing its bank account. This account is called the Treasury General Account (TGA), held at the Federal Reserve. In normal times (if you remember what normal times felt like…), the TGA usually has hundreds of billions of dollars. During the COVID spending spree, it even reached over $1 trillion. However, as of last week, the TGA dropped to around $50 billion. It might sound like a lot, but considering the federal government spent over $6 trillion in 2022, it's actually quite low. It's like having $800 in your bank account when you're spending $100,000 per year. Not good. So, the US Treasury plans to sell T-bills, lots of them. People are wondering what this means for the markets.
Well, it depends on the market. You might think that more T-bills available would lower their prices (meaning higher interest rates). But that's not too likely just yet because the world has been hungry for T-bills recently. The US Treasury couldn't issue many until the debt ceiling deal was sealed. A more plausible scenario, especially with the current interest rates, is that there's a lot of money waiting to buy those T-bills (there's evidence of this in recent Treasury auctions). So, the real issue is where that money might be coming from instead. The first possibility is cash held at banks. This could be a problem because banks would lose deposits (which they rely on for funding), possibly leading to a forced decrease in assets (selling bonds that are now worth less than when banks bought them in 2020). Alternatively, banks might have to seek funding from markets like the repo market, which had a financial scare in 2019 when bank reserves decreased (See this piece I co-wrote back in March 2020 when I was a Partner at Research Affiliates). Either way, it could trigger a Bank Crisis 2023 version 2.0, a return of the repo crisis, or some other unexpected event (I have a so-called “black swan” story for another time... Subscribe to our newsletter to hear it!).
Another issue could arise in the stock market, particularly the US stock market, which is currently full of excitement and speculation around tech and AI. Along with historical evidence suggesting that a decrease in bank reserves usually leads to volatility (code for “trouble”) in the stock market, the current story could go like this: during the first half of 2023, T-bills were seen as frenemies. They had high yields compared to recent history and arguably offered attractive expected returns relative to stocks given the current conditions. However, T-bills became scary due to the federal game of chicken over the Debt Ceiling. So, investors decided to both “play it safe” and not miss out (FOMO) by buying exciting US stocks, especially those related to AI. Now that it seems safe to return to the T-bills market, we might see some people selling stocks to “take profits.” That selling could quickly turn to pain for stock investors.
Now, my friends and former counterparts at PIMCO argue that we could be seeing the best expected returns on bonds in over a decade (check out this article). I understand their perspective, especially since we weren't likely to see such returns when bond yields were near or below zero. But it's important to consider where they're coming from and what they're selling (in this case, bond funds).
Still, we should have a serious discussion about why bonds may play a significant role in a portfolio based on the science of portfolio construction, acting as a macroeconomic hedge. We'll continue that conversation next time, keeping in mind that a good hedge at a bad price can turn into a poor investment. But as PIMCO suggests, it might finally be worth taking a look at these prices...