KERNEL BILL
EDU DDA Mar. 20, 2025
Summary: It didn’t take long for the FOMC’s QT adjustment to create an academic stir. And stir it did, stirring up an old argument still-popular on that side. One reason it remains out there is that it contains a kernel of very important truth. It is backed up by ongoing struggles by central banks and even stocks. One corner of the equity market, most of all. It all comes down to falling yields, both at the long end of the curve as well as right up front. Bills doing things and people are noticing.
It didn’t take long for the QT taper to find an audience in the Ivy League, and among former policy officials like past Treasury Secretary Larry Summers (who is both). Summers was on traditional TV touting QT as some kind of warning the government debt market is ready to blow up, in a rant not even Zoltan Poszar would touch these days. Within his diatribe (more political than economics, small “e”), though, there is a small matter of important truth.
The market really does want the short end.
However, this doesn’t mean it is purposefully avoiding the long end. If anything, what stocks and central banks are up to these days helps show why this is true.
First, though, I should acknowledge what might seem an inconsistency. I’m often asked, if I believe central banks don’t really matter, why do I spend so much of my time and yours discussing them; or Economists, too. Equally confounding, at first, why any mention of the stock market at all if equities are purely driven by a beauty contest held within the world’s largest casino.
For one, for the vast majority of the public, their entire perception of fundamental conditions is gleaned from either Jay Powell’s fatuously positive statements or the NYSE, sometimes both with little else beside. This idea is reinforced everywhere and in everything, particularly the financial media on top of social media, too. Fed. Fed. Fed. Stocks. Stocks. Stocks.
In both cases, look not at what Powell says, rather what he has done and is more likely to do regardless of public insistence. This is, after all, what has led the entire financial marketplace to its current shape – not trade wars. The rate cuts didn’t start yesterday, they’ve been ongoing for a year now.
What Economics will argue is that anything which may have created doubts and even fear last year is unrelated to the “uncertainty” rising this year. That’s plainly and patently false; the previous global macro trend wasn’t cleaved by the rate cutting as it began, starting anew with soft landing expectations. It has been a continuous cycle, and one that has repeatedly exhibited short run fluctuations, the infamous back and forth of the forgot-how-to-grow.
The emerging weakness of 2025 isn’t something new; it is the re-emergence of mainstream awareness how the situation isn’t going as planned or expected after the rate cutting got going (if only because rate cuts don’t actually work). Markets (not stocks) have been a constant underlying all these mini-cycles from the beginning.
That said, both the Fed and S&P 500 do offer some compelling signals from time to time, on occasion. They both happen to coincide in the (traditional) recession case. Lower interest rates from the market signal growing distress in the economy or monetary system, and lower interest rates from policymakers reflect awareness of the exact same thing.
Lower stock prices, likewise.
For the most part, shares are bid regardless of anything. When confronted with rising probabilities of recession signals, combined with central banks all over the world lowering policy rates, these are useful indicators especially as come tighter together.
The Fed may not be ready to move again on policy right at the moment, stocks and bonds are thinking a greater chance they will. After staging a rally (both) yesterday on what was perceived of as a “dovish” Fed (ignoring the dots in favor of QT, or statements alluding to policymakers being ready to lower policy rates even more in the face of weakness), today saw the equity markets whipsaw back and forth.
Down in the early morning, giving everything back from the FOMC, then an intraday rally spurred by existing home sales (yeah, I know), only to watch it faded into the close. Dip buyers are trying to buy dips, they just can’t – right now – convince everyone else to jump back in.
Looking behind the big caps, too:
The Russell 2000 Index is solidly in correction territory, down 16% from its peak in 2021, with companies facing uncertain demand as businesses weigh the fallout of Trump administration’s trade policies. The group that relies on domestic sales for 77% of its revenue, according to Jefferies, is often seen as a harbinger of stress in the economy. While small caps aren’t signaling a recession yet, there are other reasons for concern.
The Russell 2000 was one of the biggest gainers among equities after President Donald Trump won the US election in November. Investors piled into the group, expecting it would do well in a protectionist regime given the companies’ largely domestic operations…But that rally faded as doubts emerged about the impact of tariffs and as worries grew that the US economy has started to cool. Smaller companies — typically less profitable and with greater debt loads than their larger counterparts — are usually the first to feel the pinch.
As one mainstream stock strategist said, “Small caps do tend to be the canary in the coal mine, and right now the canary is coughing and soon might keel over. This higher-volatility group is likely to surrender its gains more quickly than large caps in the face of a recession.”
Just like in the real economy, the combination of several factors created a distortion – not an end to the prior trend or cycle – which manifested across different sectors and dimensions of the markets and macroeconomy (the latter supported, or seeming to have been, ironically by fears over tariffs driving what is being revealed to have been an enormous frontloading of demand in the goods economy, impacting the services economy, too, for how much of it is dedicated to managing, transporting then ultimately selling items).
Neither the markets nor the rest of the world are quite there just yet. As of right now, it’s still forgot-how-to-grow rather than remember-how-to-recession. The probabilities are growing, not lessening as they should if last year wasn’t influencing this year.
This is the reason why LT bond rates have slumped as far as they have since the middle of January. Benchmark 10-year Treasury yields have traversed from around 4.80% then to under 4.20% as recently as this morning. Along the way, the buying has conspicuously flattened the yield curve, even going so far as to re-invert at the broad 3-month to 10-year interval. The 2s10s have compressed noticeably, as well.
You’d therefore think the market isn’t really concerned about another burst of deficit spending. Set aside any ideas of DOGE or its intentions, there is a growing chorus who are saying deficits are permanent at their current levels. Thus, too many Treasuries all over again. Bond markets, they say, are in imminent danger of being blown up by supply.
What Larry Summers claimed today was that the Fed’s QT was actually a signal the FOMC is worried about that very possibility. Even after acknowledging the significant downdraft in LT yields the past several months, though without allowing this happened in defiance of his and others’ predictions otherwise, Summers says the dramatic slowdown in the Fed’s balance sheet runoff (QT) is so that dealers can have enough capacity to absorb much larger supply (Zoltan’s old theory).
He then says the market’s preference for ST debt is evidence for this. It’s not quite the Activist Treasury Issuance nonsense offered by Nouriel Roubini which created some buzz last year (rather quickly forgotten). Basically, ATI accused the government of a stealth QE holding LT rates down by not issuing more debt at the long end.
As you can see, these people all believe that the bond market is a slave to supply. They really do imagine (they have to) Treasury buyers’ horizon is only a few weeks, maybe days at most, revolving entirely around the issuance calendar. Everyone operating in it is dependent solely on the auction process (again, the lingering foul aftermath of Zoltan), unable to perceive of any other factors beyond the Treasury’s deficit decisions.
Summers is making basically the same claim from a different perspective. Both positions recognize the preference for ST debt, yet make it into a government decision rather than a market one. And even if they did acknowledge the distinction, they still argue the lack of a supply at the long end is a significant (if not the only) factor depressing long-end yields.
To begin with, they all believe inflation is a permanent challenge therefore the ongoing race to the bottom among central banks – including the Fed – is destined like the bond really to be short-lived. Everything with these theories is entirely backward; no surprises, given Economics. This is why we have to spend so much time on it and everything which comes from it.
As discussed in detail yesterday, the systemic level of bank reserves makes no difference to anyone except Economists and central bankers (same thing). Just like holding cash vs. holding bank reserves, the amount of bank reserves is immaterial for dealer banks or any other depository institution contemplating buying Treasury bonds. If there aren’t reserves available, there are a number of other options including other, more useful forms of cash not to mention repo.
Especially the zero-haircut variety offshore.
The considerations driving the financial marketplace, starting with dealers, have little if anything to do with Treasury supply and everything instead derived from growth and inflation expectations. The problem, one of them, is these Economists don’t like what those explanations say about their own theories and even their grasp of basic economics.
If the last several years didn’t prove that beyond any doubt, with monstrous deficits and issuance which didn’t blow up the Treasury market, nothing will which simply means these Economists are zealots. The current, ongoing bond rally got started during the height of that supply-soaked stretch. And going back to before October 2023, bond rates had been mainly sideways from the year before even as central banks were still engaging in dramatic rate hikes.
Even more damning, the correlation and co-action of bond rates from all over the world. Why would Treasuries correspond to closely with German bunds and schätzes when the issuance profiles for each issuer are as night and day different as you can possibly get.
The kernel of truth in all of this is the persistent deep demand for ST instruments; everyone loves and wants bill. Why? To Summers like Roubini, they both believe it is distaste for longer-term debt given, you know, the inflation monster lurking right over the horizon. If that was truly the case, they’d be right and no one would want to own longer-dated safety.
It’s all rubbish. We’ve seen time and again heightened buying bills for years. In 2017, for example, during globally synchronized growth reflation, while the Fed was hiking rates, the financial world was forecasting an uptick in inflation, and Zoltan was perfecting his “too many Treasuries” theorem, bill yields were likewise persistently lower than they should have been. It wasn’t distaste for longer-date instruments at all.
In fact, I showed the answer to this in yesterday’s DDA. Here it is again:
Despite the deficit fears of 2018 following the Tax Cut and Jobs Act of December 2017, combined with inflation forecasts, the long end of the yield curve did just fine anyway. The entire Treasury curve had flattened in an unmistakable sign of additional demand for longer-term debt only an Economist would miss or misinterpret especially in the face of Fed interference (rate hikes).
The reason why bills were in demand was a shortage of them for other purposes, namely collateral. It wasn’t fear of long-term debt which created extra buying at the short end. The collateral scarcity problem only got worse into 2018 and helped lead to the “unexpected” global setbacks in 2019, especially November 2018’s landmine development then September 2019’s repo – not Treasury - blowup.
Or what the flattening yield curve from 2017 was warning about while completely ignoring the large increase in Treasury supply. Fundamentals always drive interest rates, not central banks or central governments (just ask Beijing).
This leaves us with a bit of a puzzle, however. Acknowledging the general reasons for bill demand, we now have to consider some specific motives. Bill rates right now are lower than they “should” be when compared against alternatives like the Fed’s IOR, even the RRP, SOFR and term SOFR. Front end bills are yielding almost nothing above term SOFR and are now persistently below IOR.
Why?
Forget Summers’ idea of eschewing long-term notes or bonds, those have been bid heavily the same time this has been going on up front.
One possible explanation is rate cuts; the bill market is willing to give up some real money return today anticipating lower front-end rates in the not-distant future, meaning the Fed lowering rates even if today it has no plans to do so. While that’s certainly a consideration, we don’t see anything else which corroborates that view; other bills like the 3-month maturity or term-SOFR let alone term-SOFR futures, the rate cutting doesn’t look likely or within the maturity window of the bills which are seeing growing buying.
That leaves us wondering about collateral scarcity. Not quite a shortage let alone a scramble shortfall, still some scarcity. The upcoming debt ceiling isn’t directly a factor, as in 2023 when investors and bill buyers (MMFs) would avoid specific maturities out of abundance of caution to make sure they weren’t holding any paper which might have a missed coupon payment because the government was out of cash and borrowing capacity.
However, the debt ceiling is impacting the market in terms of…supply.
Yep, like I said above of central banks and stock markets, supply isn’t a factor until it is. What I mean is, it doesn’t impact the market when the government is issuing more bills or notes. Going the other way, however, there can be material problems, such as 2017, 2023, and a bit so far maybe in 2025. Bill issuance is down and that could be driving prices somewhat higher.
As might what’s going on more recently in corporate credit. The rise in credit spreads, while not catastrophic, is noticeable and has been significant which does impact collateral considerations (haircuts and collateral calls). It’s enough to notice, if not be overly concerned about just yet.
What it doesn’t add up to is the market staying away from the long end due to inflation that has yet to show up in the manner all these bond market “experts” keep saying. And with stocks and central banks doing what they’re doing, the chances for it and for bond rejection of the long end is going down with yields at the front and back.
