The GOP's Fiscal Surrender: Why A "Yield Shock" Is Baked Into The Cake

The US Treasury is fixing to sell the staggering sum of $294 billion in bills, notes and bonds this week, and it's a holiday-shortened week at that. So you'd think the bond market would be choking at least a tad on this tsunami of paper, but in fact yields on the 10-year UST have slid 20 basis points recently and are now at five-week lows.

To be sure, at 2.75% the yield is still 140 basis points above it mid-2016 post-Brexit low; and its is only a matter of time before the treasury benchmark resumes its upward march through the 3.00%mark on the chart below and from there toward 4.00% and beyond.

In fact, that impending "yield shock" is so baked into the cake that you can smell it burning on the bottom of the pan. By contrast, the minor head fake in the opposite direction this week is just the boys in the bond pits buying a silly rumor and squeezing some folks who perhaps got too short too fast.

Here we use the word "silly" purposefully. The chatter at the moment is that the so-called inflation scare from the 2.9% reading on January wages has faded markedly, and that the Fed consequently may find a reason to ease the pace of its rate hiking campaign or even end it early.

As former Lehman trader and now Bloomberg macro commentator, Mark Cudmore, recently noted:

Tomorrow brings February’s PCE data, supposedly one of the Fed’s preferred inflation measures. The consensus forecast is for the core number to climb to 1.6% year-on-year. That paltry rate of inflation would still be the highest since since March last year.

A miss of just 0.1 of a percentage point and investors will start considering the possibility that inflation may already have peaked, and hence perhaps so has the Fed’s rate-hiking cycle. That would put the cat amongst the short Treasury pigeons (positions).

It’s not going to take too much for serious discussion to begin over the possibility the Fed’s hiking cycle may be at an end, or near an end, already.

With all due respect (i.e. not much) neither the second decimal place on the PCE deflator nor the precise number and pace of "hikes" in the Fed phony" target rate" has anything to do with the impending "yield shock".

Recall that in the aftermath of the Fed's QE madness there are still $2.1 trillion of excess bank reserves on deposit at the Fed, meaning that the Federal funds market is still deader than a doornail. What the Fed's "target rate" consists of, therefore, is the pro forma rate (now 1.75%) at which the FOMC---purportedly in its wisdom---confers windfall IOER (interest on excess reserves) payments on member banks.

At the moment that amounts to $37 billion per year of profit goodness for the banks, and if the Fed should dither again and raise rates only one more time this year rather than twice as promised at the March meeting, the IOER payment by December would annualize to $42 billion rather than $47 billion.

But a $5 billion difference among thieves banks will make no matter at all in the bond pits. That's because what is happening in the latter is a monumental monetary/fiscal collision. The Fed is dumping its swollen balance sheet at the very time that the Trumpite/GOP has kicked on the deficit after-burners with positively reckless abandon.

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