In only the last three weeks or so, we have seen a head spinning progression of different narratives driving markets. Oh how I yearn for the anchor of the Three Phases Model now, but sadly its time has passed. For today’s post, I’m going to briefly cover a range of topics which span various themes. They may sound disjointed, but frankly, the market has been forced to lurch from theme to theme as monumental policy decisions are made, second-guessed, and occasionally rescinded by seemingly inscrutable human beings. The situations are frustratingly hard to analyze, but I offer some thoughts here nonetheless. This is not a commentary on whether the goals of the Trump foreign policy are potentially helpful to the long-run prosperity and security of the United States, but rather I’m trying to address the impact of a binary change in the short-term outlook for growth and financial asset prices.
By the time this note is published, I think it will be obvious, but the breakdown in US-China trade negotiations has abruptly taken over as the most important theme driving markets. If the global economy proceeds through the rest of the year with the most recent bi-lateral tariff hikes in place, those tariffs should be a material headwind to growth. A headwind, it should be noted, which was priced with only a miniscule chance of happening prior to Trump’s tweets on Sunday, May 5th, and which markets are still having a hard time accepting. So while the narrative of “trade war themes aren’t going away – just get used to it,” is an encouraging idea for those looking for risk market upside, the actual tariffs and lingering uncertainty are quite likely to genuinely impact growth precisely at a time when high valuations were built on green shoots of improving global growth in 2H 2019. Though of course, there is still a possibility that a “deal” will happen around the G-20 in late June, risk premiums ought to be wider now because the downside economic risk with persistent (or even higher) tariffs is significant. Global recession probabilities will need to rise.
Another consequence of the tariff hikes and postponed trade agreement is the sudden de-emphasis of the inflation data in the US as it relates to the likely monetary policy pathway. Fed Vice Chair Richard Clarida constructed a narrative ahead of the May 1st FOMC meeting that advocated for “insurance cuts” in the policy rate because inflation was persistently missing the 2% target. I had a blog mostly fleshed out in my head about whether more inflation was a good and desirable thing for the health of the economy or an absurdly inappropriate cost of living increase which would impact families inversely proportionate to their incomes. And then at the press conference, Chair Powell steadfastly refused to take the bait on the idea of “insurance cuts.” In fact the word “cut” was uttered eight times during the press conference, and all eight were journalists trying to trap him. In the days that followed, Clarida and others walked back the insurance cut idea, but then the whole thing was rendered moot by the breakdown in trade negotiations. From here, the future policy pathway is dependent instead on the trade war impact on global growth, and on the Fed’s response to foreign central bank monetary easing. Even if the US continues its record of exceptionalism versus other developed economies (quite likely in my view), the Fed would follow suit in leaning dovish into trade-related headwinds.
But what about inflation? Don’t tariffs raise prices? Well yes, that’s the whole point. But, much like a large energy price spike or consumption tax increase, this sort of inflation is not desirable, is generally considered a one-time spike, and the Fed would probably ignore it as a reason not to cut rates. In fact, tweets like the following illustrate the extent to which the Fed may be boxed-in by trade-related growth headwinds:
“China will be pumping money into their system and probably reducing interest rates, as always, in order to make up for the business they are, and will be, losing. If the Federal Reserve ever did a “match,” it would be game over, we win! In any event, China wants a deal!”
— Donald J. Trump (@realDonaldTrump) May 14, 2019
The president can pressure the Fed, but also the economic realities would probably justify a cut, so the Fed may struggle to distance themselves from the appearance of political interference. Additionally, the perceived ability of each country to respond as needed with monetary and fiscal stimulus is hardening their respective bargaining positions, and in my view reduces the chance of a resurrected comprehensive deal.
The upshot is that while risk assets may continue to experience bear market rallies, especially in the US where exceptionalism may even intensify, valuations need to adjust in aggregate to account for the material change in outlook for global growth in the past two weeks (purely due to human decision-making). As long as global growth concerns are still developing, interest rates should trend lower in yield regardless of whether markets expect central banks to respond dovishly, or central banks fail to see the need to respond, or in the extreme, if any response is ineffectual. Additionally, while the rapid reduction in US dollar liquidity I discussed two months ago did not, itself, trigger a risk-off move, the reserve drain did accelerate as planned and liquidity remains somewhat tight, which can exacerbate downside price action. One last comment on the dollar: it’s a countercyclical currency, especially when accompanied by US exceptionalism, so expect it to remain strong while the trade war narrative dominates and foreign central banks make the first dovish moves.
Treasury STRIPS: State of the Market
Origin of Treasury Stripping
First introduced in 1985, Treasury STRIPS are zero coupon bonds comprising either the principal or individual coupons of U.S. Treasury notes and bonds (termed principal STRIPS and coupon STRIPS, respectively). Initially created by bond dealers literally “stripping” the physical coupons from bearer notes and bonds, the Treasury eventually created the STRIPS program to facilitate the stripping (and later also reconstitution) of US Treasuries and to improve liquidity by, for example, unifying the CUSIPs. Though the Federal Reserve now assists with the logistics of creating and servicing these bonds, the supply of STRIPS is still exclusively controlled by private dealers.
Current Market for STRIPS
Long-dated STRIPS – the most prevalent type being created – are often purchased as a means of adding duration in a liability hedging context. Outside of derivatives, they are one of the most capital efficient ways to add interest rate duration, so typical buyers of STRIPS include corporate defined-benefit pensions and life insurers with USD liabilities.
The influence of corporate pension demand on the STRIPS market was evident in 2018 following the US tax law changes. Corporations were incentivized to contribute to their pension plans, leading to improved funded statuses. As a general rule, better pension funded status corresponds with lower risk appetite and thus a higher fixed income allocation. Often de-risking is also associated with a higher interest rate hedge ratio, or the dollar duration exposure of assets relative to liabilities. As a result, there was sustained demand for STRIPS leading into the September 2018 tax year deadline.
Pension funded statuses have improved some year to date given the equity market rally in the US, though falling discount rates have partially counteracted this. Improved funding may create additional STRIPS demand if equities hold in and discount rates stop declining . As seen in the chart below, STRIPS creation generally occurs when US pension funded statuses are improving.
Despite the recent and forecasted demand for STRIPS, they still trade with less liquidity than other Treasury securities. This is especially the case for coupon STRIPS due to their lower principal amounts. As a result, coupon STRIPS yield more than principal STRIPS, and principal STRIPS more than whole Treasury bonds of the same maturity (see chart below). As demand has abated recently though, the basis between coupon and principal STRIPS – and of both relative to whole Treasury bonds – has widened. Bid/ask spreads have also increased in the STRIPS market indicating higher liquidity premiums and reduced demand.
Upcoming & Potential Developments
Because of the relatively lower liquidity for STRIPS, there are a number of conversations in the market on potential improvements, both for STRIPS specifically and more broadly across fixed income. If implemented, this would have a ripple effect that should tighten the basis between STRIPS and their equivalent whole bonds.
The most immediate, impactful change to the market is dealer sponsored repo facilities, which have been fully approved and are likely to be implemented within the next few months. Sponsored repo enables approved financial institutions to novate certain cleared repo transactions to FICC. In essence, this allows banks and dealers to net repo transactions with sponsored lenders and sponsored borrowers, thus reducing the capital constraints of participating in repo markets. Dealer balance sheets are generally optimized for capital efficiency, and the coupon remnants from creating STRIPS can inhibit this. By improving their ability to utilize balance sheet assets in the repo market, fixed income market liquidity should improve more broadly, including for Treasury STRIPS.
It has also been discussed amongst market participants that the Federal Reserve could allow its open market operations account to be used for stripping, which would reduce the onus on dealers to use their own balance sheets when stripping or reconstituting.
Additionally, the January 2019 TBAC (Treasury Borrowing Advisory Committee) presentation proposed issuing long-dated zero coupon Treasuries as a means to fund increasing borrowing needs in a way that also meets and encourages domestic Treasury demand. The TBAC also suggested ways of increasing liquidity in the STRIPS market, such as making coupon and principal STRIPS fungible.
These proposals admittedly range from very preliminary to near implementation, but are a clear acknowledgement that there is room for improvement in the market structure for fixed income trading. And while Treasury STRIPS are an important part of today’s pension fixed income landscape, there may be enhancements still to come.
 “Separate Trading of Registered Interest and Principal of Securities”
 As of March 31, 2019, there was $301 billion of outstanding STRIPS, of which $291 billion was from Treasury bonds (versus $10 billion of Treasury notes).
 The rule of thumb relationship between discount rates and funded status: lower discount rates reduce funded status because the duration of a plan’s liabilities is generally greater than the duration of their assets.
 Fixed Income Clearing Corporation (FICC), a subsidiary of the Depository Trust & Clearing Corporation (DTCC) which handles processing and clearing of fixed income transactions.
 The System Open Market Account (SOMA) contains the Federal Reserve Bank’s assets acquired through open market operations.