Mark Cabana on the Fed, QT and Treasury Funding

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1:27Hello, and welcome to another episode of the Odd Lots podcast. I'm Traci Alloway. And I'm Joe Weisenthal. Joe, it's a busy week. It is a busy week. It sort of snuck up on me. You know, I knew it was Fed week. Like, it's also jobs week. It's also, and I'm not even sure, like the degree to which it matters, quarterly refunding week, sort of controversial. There's a lot going on. I got tipped off to the fact it was quarterly refunding week when everyone started talking about deficits on Monday. Oh, yeah. Because we got the estimates of borrowing needs. Yes, everyone. That's the day suddenly everyone becomes really worried about the credit worthiness of the future United States of America.

2:05There's this theory that's going around. It's kind of controversial. I see it on Twitter sometimes that like this is really important for markets that like some mix of bills and bonds and how much really matters. I don't really know. I'm like sort of like skeptical, but maybe there's something to that. But, you know, a lot of moving parts right now. And of course, it is Fed week. I don't think anyone expects a rate cut, but I think the expectation is some sort of like maybe declaration of victory and which can then be used to set up the beginning of the cutting cycle. Well, it's interesting you mentioned this theory about it having a potential impact on markets, because, of course, the other thing that we expect the Fed to discuss this week is quantitative tightening.

2:49So the shrinking of the balance sheet. And I find this is the thing that gets people really riled up, the idea that, you know, stocks are up because of central bank liquidity. And once QT begins, it's all going to wash away and stocks are going to fall. Of course, we haven't seen that, but we're still waiting on a lot of additional info about the size, the shape, the speed of QT. And there's a lot of discussion over whether or not that could change. And I should just say the meeting is tomorrow, but I don't think we're going to get a lot of detail on QT until the minutes actually come out in February.

3:23But the point is there is loads to discuss. Yeah, totally. You know, and the one thing I'll say to on the balance sheet, I'll say two things. One is that for a long time, it was just the story. The Fed is pumping money into the market, and as soon as the balance sheet starts to shrink, then that's going to be bad for risk assets. That, in my opinion, has now officially been disproven because the balance sheet has been shrinking basically since the middle of 2022, and stocks are at all-time highs. So that's over. That story, it's a thesis, it's broken, in my opinion. But what it means for banks, what it means for bank liquidity, how far they can shrink it before it creates problems, such as what we talked about, I think it was in 2019.

4:04This still matters quite a bit. And there's still interesting policy questions related to that. Absolutely. So who better to discuss all of these issues than Mark Cabana, rate strategist over at Bank of America. Mark, thank you so much for coming on the show. Thanks for having me. We are longtime fans of your work. And it's kind of a treat for us that we could do this and release the episode on the day of the Fed meeting. So we're recording it just the day before. So we're going to get all your thoughts on what's going on at the moment. But with your rates hat on, when you look at a week like this, when you have the QRA, you have jobs, you have the Fed, what are you most interested in?

4:45How are you weighing those different events? Sure. Well, thanks for having me. I'm also a big fan, so it's a real thrill to be here. Thank you. So when we think about the rates outlook, we think that the expected path of the overnight rate is really the most important determinant of where rates go. Henceforth, the Fed is clearly the most important consideration for us this week. The payroll report and other data this week will inform that. And then, still important, but perhaps secondary, is the quarterly refunding from the Treasury, that supply announcement. Though I agree with Joe, it has certainly been a focus in markets, and probably much more so than the U.S.

5:17Treasury ever would have wanted. And that's really because they've surprised the market with the last two refundings. Oh, that's right. Because wasn't it the August refunding announcement that like kicked off that initial big surge in bond yields? And then it was the November one that kind of calmed things down? So, yes, that's generally right. So they surprised by issuing more longer dated coupons in the August refunding. They then surprised by issuing fewer long dated coupons in the November refunding. And this was seen by the market as a factor that was a meaningful driver of where term premium was going.

5:49Now, I'm using air quotes as I say that. I know your listeners can't see the air quotes. But that is because term premium is sort of this catch-all unexplained factor, at least by certain Fed models. And I think one can view term premium with a healthy dose of skepticism. But nevertheless, the market perceived that those supply announcements were big drivers of movements in term premium. By the way, for listeners, Tracy, that was a minute ago I was drumrolling that sound because I always love when eminent guests confirm my biases. So nothing feels better than that. Setting aside market perception, in your own work, how important was the mix?

6:30So I guess there's two elements. There's just the total size of the borrowing each quarter, which is just a sort of economic reality that is just the gap between expenditures and the amount the government brings in in taxes. And then there is, okay, there's that mix that you described. How much is the Treasury going to issue at the long end versus the short end? How important are these things to you? Setting aside what the market perceives or even what the market did, when you see these announcements, what are you looking for and how significant are they? So they certainly matter in terms of the relative mix of what Treasury is going to issue and how the private sector is going to take that down.

7:04But in terms of determining the overall direction of bond yields, we think that they are secondary. Important, but secondary. And what's more important is macroeconomic information, growth, inflation, jobs, etc., and how that's expected to impact the overall path of the Fed. And what we saw really in the third quarter was, yes, you did get a larger than expected supply announcement from the Treasury, but you also had nominal GDP that was running at about 5 % real, 9 % nominal. That, we think, was the much larger driver of the movement in rates. Treasury supply announcement didn't help, but again, we think that the sharp upward move in rates was largely driven by better data.

7:42And conversely, in the fourth quarter, data moderated to some extent. The Fed turned more dovish. The Treasury surprised to the downside on supply, and that helped reverse some of the big move that we saw in late summer, early fall. So, these supply announcements from Treasury, they do matter. They influence market perception. They certainly matter in terms of how investors think about how much supply they're going to have to take down, how aggressive or not they are to bid, how dealers manage the inventory on their balance sheets. But generally speaking, we do think it's a secondary factor, secondary to the incoming economic data that influences the expected path of policy.

8:15Mark, one of the other narratives that became kind of popular over the past year or so was this idea of who is going to buy the bonds. So, you know, with inflation rising, with the deficit growing, with a lot of natural buyers potentially stepping back, maybe some geopolitical concerns mixed in there, there was this narrative that the traditional buying base of U.S. Treasury debt wouldn't be as large as it had been previously. And yet, fast forward to the end of 2023, we had bond yields on the 10-year basically taking a round trip. They're a little over 4 % right now. What do you think about that particular narrative?

8:53Yeah. So the number one question that we were getting over the course of 2023 is indeed who's going to buy the bonds. And it is a challenging question to answer when you are seeing inflation surprise to the upside, when the Fed is more hawkish than expected, and when bond yields are losing value. No surprise, investors don't really want to buy bonds when they're not holding their value. And as a result of that, we did see that demand weakened from a whole host of traditional investors over the course of 2023, though they did come back to some extent towards the tail end. Now, when we think about who's going to buy the bonds, we really think about maybe four or five traditional buyer bases.

9:30Banks, pensions and insurers, overseas investors, asset managers, and then the Fed, and whether or not they are buying or selling at any particular point in time. They're obviously selling right now. For those buyer bases, we really saw a transformation in 2023 from those who really had stepped away from the market largely in the first three quarters of the years, or some that had tried to buy tens at, let's say, 4 % and then got burned as tens rose much more materially over the course of the year. And they had really taken a step back. But once we saw macroeconomic data, certainly inflation data, confirmed that the peak in inflation was over, that the Fed was not going to be hiking much more, likely next step would be cutting, we saw that demand return quite meaningfully.

10:16And we've seen that from those traditional buyer bases. Banks, commercial banks have stepped into the market moderately. Pensions and insurers, we see they have generated the largest amount of stripping activity. Stripping, remember, is when you separate a long-term treasury security into a principal component and an interest component. They like to buy the principal components because they're essentially zero-coupon bullets after they've been stripped. They have low dollar values. They can add duration easily, and that helps them manage their overall liability mix. But that pension and insurance community, we think, has stepped back a bit.

10:51some foreign demand has reemerged, not from Japan, not from China, but from other parts of the world has emerged. And we've also seen that asset managers have been returning back to the market as yields stop rising. We're also now talking about the possibility that the Fed will go from as active of a net seller through QT. They don't functionally sell into the secondary market, but they're responsible for more supply that the US Treasury in turn has to issue to the private sector. And they're talking about slowing QT. And now we're wondering, well, if they're slowing, when might they stop? So that is an important determinant in shifting some of the supply-demand dynamics in the rates market.

11:29So that's a long-winded way of saying that we have seen those supply and demand dynamics shift. Really, demand is returned to some extent. And we remain cautiously optimistic that that demand will persist over the course of 2024, assuming that macroeconomic data continues to play along with the broad narrative of slow moderation over time. let's talk about quantitative tightening. You know, like I said, in the beginning, there's always been like this one, I guess I would call it like Twitter macro, or it's like one line goes up, another line goes up, they must be connected. And I think the idea that like balance sheet policy is some incredible driver of risk asset valuation is kind of debunked.

12:06But when we're discussing how far they will go to wind down and at what level that will be, who does that really matter for and why? Like who are the actors in the market that for whom this is an important debate that they're having. Sure. I generally think of two or three actors for which it really matters in terms of how far the Fed shrinks the balance sheet. First and foremost, commercial banks, because they can be directly impacted by the amount of reserves or overnight liquidity that the Fed is providing to commercial banks or that is available in the system that commercial banks can try and bid for.

12:39The second big actor is treasury and mortgage market participants for whom, if the Fed is shrinking its balance sheet or growing its balance sheet, the total amount of private sector supply in the treasury or agency mortgage market can be directly influenced by that. And then the third cohort, and Joe, I think your comments have referred to this on a few times, is sort of the broader risk asset investor. I almost think of them as the quote unquote M2 equity investor, the type of equity investor who just wants to buy or sell equities based upon what's happening with the broader money supply. And this, I will tell you, is a very real cohort of the market, at least as far as the folks who reach out to us on the B of A rate strategy team.

13:18We also view it with a healthy dose of skepticism. We don't believe that there is a particular clear connection between how many reserves, let's say, are in the banking system, and then what's going to happen with the equity market. But that doesn't dissuade them. They look back at history and they say, well, when the Fed was growing its balance sheet, risk assets did well. When they shrunk the balance sheet or reserves went down, the opposite happened. And really what we think they are picking up on is the fact that the Fed and other central banks use their balance sheets to almost reinforce the broader stance of monetary policy, right?

13:48So if they're growing the balance sheet, they're typically doing so because they're trying to stimulate activity, lower long-term borrowing costs. And if they shrink the balance sheet, they're generally trying to tighten policy and they're raising interest rates at the same time. So if you think about the balance sheet as reinforcing the broad stance of monetary policy, we think that the M2 equity trading stance makes sense. But we would encourage investors not to blindly follow what happens with the balance sheet or with the reserve quantity and system as an indicator of buying or selling risk.

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15:48See how your business can get stronger and go farther with Chase for Business. Learn more at chase.com slash business. Chase for Business. Make more of what's yours. The Chase mobile app is available for select mobile devices. Message and data rates may apply. JPMorgan Chase Bank N.A. Member FDIC. Copyright 2025. JPMorgan Chase and Company. There's one sort of under the radar thing at the moment that I think is going to end up being a big deal in 2024, which is sort of the changes around liquidity requirements and regulation for banks and all of that happening against the broader backdrop of QT.

16:27But how do you see that playing out? Because there's a number of things here. So, you know, there are the Basel endgame proposals. There are LCR suggestions that maybe make those liquidity ratios get a little bit bigger. There's changes to, I have to be careful here because I always end up saying BTFD. The BTFP, not by the F-ing dip. the BTFP and a few other things happening in the background. It is funny though. It's so funny. This was a market mantra for like 15 years and then the Fed came out with an emergency program in March 2023 that sounded so similar. Like let's just acknowledge that is very funny.

17:08I had never even heard of that other acronym. Oh really? BTFD? You need to spend more time online I think. Dear Fed, you might want to look at Twitter before you do your next acronym. I'm glad we just acknowledged the elephant in the room here. I'm glad we introduced Mark to it. Thank you. I learned something. I appreciate it. All right. But it does feel like changes are coming for the banks and banks are big buyers of things like treasury bonds and mortgage-backed securities and things like that. So how do you see all of that playing out? Sure. So we do think that, importantly, with the recent rate hiking cycle from the Fed and what we saw with SVB and some other regional banks, that commercial banks have really changed their preferences around liquidity in a meaningful way.

17:54And this, we think, will necessitate that the Fed maintain a much larger balance sheet than perhaps they had originally envisioned to really accommodate this demand for overnight liquidity from commercial banks. And we think that commercial banks are demanding much more overnight liquidity for very rational and prudent reasons. The four factors that we typically cite include, number one, we all saw what happened with SVB. And the best antidote for that, we would argue, is holding lots of overnight liquidity. Number two, commercial banks are still sitting on fairly substantial unrealized securities losses in their treasury and mortgage portfolios.

18:35The recent rate rally has helped ameliorate that, but it hasn't gone away. And again, the best way to fight against those unrealized securities losses is to hold cash. You can tell your shareholders or your regulators, don't worry about the 2.5 % mortgage or so that I bought. I'm never going to have to sell that for liquidity purposes because I'm holding on to so much overnight cash and I have so many deposits. So don't worry about those securities. We think that's very rational in this type of rate environment. Third reason that banks are holding more liquidity is because they perceive that some of the traditional rules of liquidity management have changed.

19:12And this goes into a fairly narrow corner of the funding markets, but it's very important. And it's around the role of the federal home loan banking system. It's a GSE that arguably had really shifted from its original intention to be a low-cost, stable provider of funding for bank mortgage holdings. And regulators are, well, they've asked, does this evolution of the home loan system make sense? They think not necessarily. And that has really reduced the ability or willingness for banks to use the home loan system as a traditional funding source. And the market calls the home loans, or at least the home loans have called themselves in the past, the lender of second to last resort.

19:59And that is now, let's say, not necessarily your second to last resort. It is lower on the priority list to be used. And then the fourth and final factor is that there is a perception, as you say, Tracy, that there will be additional liquidity rules and regulations coming down the pike. And all of those factors encourage banks to want to hold more liquidity. And the best type of liquidity in the world, if you're a bank, for all of these reasons, is cash at the Fed. It is intraday liquid. And if you need it, if you were to experience a large deposit outflow, you have it at the Fed. You can get it on demand as long as Fedwire is opened.

20:39And that has real value if you are a commercial bank. And as a result of that, commercial banks have been choosing to hold a lot more liquidity. They've been paying up through more elevated sources of borrowing, such as large time deposits, CDs, other forms of term debt borrowing. And they have been doing that in order to hold more cash. And that indicates to us this increased preference to hold liquidity. And if that is indeed right, it's going to mean that the Fed is unable to shrink its balance sheet, perhaps as far as it had originally thought. Now, the question in our minds is, will the Fed slow down or stop in time to accommodate this?

21:23Or will they risk another funding market increase or sharp jump like we saw in September 2019? We don't know the answer to that yet, but folks like me who focus a lot on the plumbing are very, very interested in the guidance that we're going to get from Powell and others at the Fed as they move forward in this debate and this discussion. Since you mentioned the plumbing, you're talking essentially about the repo madness of 2019. And then we saw a little, I don't want to say a repeat, but a little glimmer of that same issue in, I think it was December of last year, when we saw not LIBOR, but SOFR, the LIBOR replacement rate shoot up kind of unexpectedly in a few days and then come down very quickly.

22:12What was going on there in your mind and how much of a concern should future volatility in the interbank lending market be for those at the Fed and us market commentators? Sure. So just a quick point of fact, LIBOR was indeed unsecured interbank funding, or at least that's what it was intended to be. SOFR is importantly secured funding that has arguably a wider range of actors involved in that money market mutual funds who are lending cash in that market, hedge funds who are demanding leverage on the borrowing side in that market. So it is a fundamentally different space. But we do think that signals from money markets are very important indicators of what this demand for liquidity at commercial banks looks like and how much excess cash may be available to keep money markets in check.

23:03Now, how does this actually work? Well, here's our understanding of it. So when we think about the repo market, we think very simply about it. It's nothing more than the relative balance of cash that is available to be invested in short-term money markets and collateral that needs to be funded. Really, treasury collateral is the most frequent type of collateral that we think of. But there's a whole host of other collateral that gets funded, mortgages, credit, EM, et cetera. But again, we just think about it as in terms of cash and collateral. And what we saw at the end of December, also what we saw at the end of November, is that we saw repo rates spike for a period of time.

23:42In our framework, that simply indicates that there is less cash that's available to fund the collateral that is in need of financing. And henceforth, repo rates go up. Now, what was happening on both sides of that equation? Well, on the cash side, what you see is that dealers typically reduce their intermediation in the repo market due to month-end and especially year-end balance sheet reporting dates. Window dressing is the preferred term. You said it, not me. It's my preferred term. And we also see that there's big treasury settlements at the end of the month and there's more collateral that needs to be financed.

24:17And so the repo market is just more susceptible to moving higher because of that cash collateral dynamic that shifts on month ends. Now, this links to what happens with commercial banks and their liquidity preferences because commercial banks are indeed a big source of cash. And commercial banks, we saw in 2018 and 2019, as the Fed was doing QT and that cash collateral balance shifted, commercial banks were big lenders in the cash market at that period of time. They were taking their overnight liquidity, investing in overnight Treasury GC repo, which is a close substitute, but importantly, not a perfect substitute.

24:54And we now see again that as repo rates are rising, commercial banks are choosing to lend a little bit more in the repo market to try and keep GC repo in check. The question we have, though, is how much cash is there truly to keep these funding markets in check as the cash collateral balance shifts? And will these banks be willing to take that cash that they're sitting on with the Fed that is perfectly intraday liquid and exchange it for T plus one liquidity for yield enhancement? That is the big question that we ask ourselves. That is the question that the Fed, I think, is asking themselves. And that will ultimately be what we believe is the driver of how far they can actually shrink the balance sheet.

25:37Out of curiosity, do you see any interplay with the recent changes to the BTFP, the emergency bank funding program, and big banks' willingness to fund repo? It's too soon, I think, to tell. But in theory, you can imagine that there would be a connection. Because the BTFP, for as long as it was going to be available for new loans, served as a cheap, low-cost source of additional liquidity that banks might want. that the liquidity was available on very favorable terms, not just price, but the facility was set up such that it funded treasuries or agency paper at par, not market value. And that's a big difference when you've got overnight rates that are still above 5%.