Hive Intelligence Report: The Impact of QT, European Demand, and VIE Structures

Every week, we bring together our community of macro experts to discuss the latest market developments. In this piece, we distil the insights from our conversations up to 7 February. These are views from our network rather than the views of the Macro Hive research team. ‘[Day]’ indicates the day the comment was made.

US

TGA

• TGA is close to Q1-2022 target (~$640bn). The US Treasury is to borrow $729bn in Q1-2022, $254bn more than previously anticipated last November.

Treasury funding schedule versus expectations

• They announced on Wednesday the distribution on the curve. Less on the 7s and 20s, which wasn’t much of a surprise. QT can always match these.
• Dealers’ estimates were all over the place but all within the average expectations.
• It’s not clear how many additional cuts are possible. For example, cuts in May are more likely to be focused in the long end and the 2-5Y space will be left unchanged. The Treasury Borrowing Advisory Committee (TBAC) is assuming the Fed starts the runoff in July and ends it when the SOMA holdings are 23% of GDP. Above $90bn of monthly runoff and QT becomes active – the UST runoff is maxed at $60bn and the MBS runoff is maxed at $30bn.

A conversation on the impact of QT

• They could change the sequencing. But so far, they have stuck to it.
• The estimates about the impact of QT are very reasonable: expect 10-year nominal yields about 30-40bps higher. This is assuming the Fed lets the maturities roll off. This is not about actively selling.
• But most of these estimates are ceteris paribus. Hard to extrapolate them. The other problem with those estimates is that they are derived from the period where QE is first deployed and where it is most effective. Most estimates derived from QE rounds that were outside the window of a crisis find a much smaller impact. The impact will be less than estimates. What is worrisome is that the experience in Europe has been different to the US or UK experience. In Europe, for several reasons, we had a proper central bank squeeze in German paper. Not sure that unwinds, but if it were to unwind it would be a real issue for global bonds.
• QE, tapering, and QT will not be symmetric in their effect on the level and slope of the curve, and on risk assets (such as tech). So, historical data on previous Fed balance sheet versus asset price relationships may not be very useful. There will be non-linearities related to the size of the balance sheet: level versus change, potential for hiking into a recession etc.
• The impact of QT should be less than QE if anything. Bonds maturing, that is passive QT, should have less of an impact than buying duration, that is QE. Hence the 40bp, which is a QT estimate derived from regression QE period, serves as an upper bound.
• It’s hard to see how the Fed would resort to outright sale of bonds.
• Yes, but tools will be limited in a stagflation type of scenario. There is not much from history to help him. Powell is also not a decisive guy, unlike Greenspan, Bernanke, or Yellen. So, he will use consensus from the committee. Whenever decision is based on a consensus among a large group of people, they tend to be overly risk averse.
• There are so many other ways to tighten – politically it would be explosive.
• Powell might not care much about politics.
• Powell is the most politically influenced Chair of the Fed in recent history.
• But after confirmation he will be a different person. The Fed would also like to hold only treasuries on its balance sheet. But we won’t get much MBS runoff because the MBS book is not refinanceable.

Conversation two on the impact of QT

• The problem with a protected $100bn per month of QT is that the caps don’t fit unless they are actively managed. If you look at the maturity profile of the SOMA UST profile, there are quite a few months when coupon redemptions are below the $60bn UST cap: they either have to actively sell or switch to Treasury bills. Or they can do more in months when the redemption is larger than the cap, and less when the other way around, and still average $60bn. The MBS SOMA redemptions are also very unlikely to hit the $40bn cap per month as higher rates will push down paydowns. But the Fed is more likely to actively sell MBS than USTs. The impact on the UST coupon yield will depend a lot on whether the Fed decides to run down its Treasury bill portfolio more, at least at first, than coupons, and where the US Treasury decides to fund along the curve. It makes sense to fund in Treasury bills as they are still quoted below the US Treasury target and given the size of RRP they can easily be absorbed.
• Again, these estimates are derived ceteris paribus, most typically by estimating impact around windows where QE is the main market driver, or less frequently by controlling for other factors. So, say QT has a 30bp impact, but as ISM comes below 50, growth is soft in H2, then it would be hard to see much in 10-year yields.
• Plus, the fact that its already being priced in now.
• You need to assume that the market is significantly distorted by QE and the mere absence of it, despite reduced issuance, will be enough to materially push yields higher.

Why aren’t hikes enough?

• They might be. But shelter (housing) inflation may be hard to tame.
• This is not a credit fueled housing boom though. And, to this day, I am yet to see the rampant shelter inflation. The main item has been this extraordinary demand for goods due to Govt cheques and pandemic effects.

Is there a problem with central banks?

• The problem with central banks is that they are backward looking. So, they may continue to sell when the market conditions have changed. So, initially QT does not do anything, central banks get confident and continue. But either the market changes or ISM is below 50 by mid-year, or something else, and they do not adjust and then the non-linear part of QT will hit us. May not be USTs, it may be credit, FX etc. Who thought about repo last time?
• This is hard to buy. When financial conditions tighten, they do not tighten by a touch, they roar. And usually when they do, central banks step back. This was the 2015 Fed experience.

Employment and market implications

• Was there any weakness in this US employment data?
• Unemployment higher (dovish), NFP higher (hawkish), AHE (hawkish); Z4 interest rate futures should push old lows, Z3-Z4 to go wider, stocks down, USD up.
• Shouldn’t a strong labour market be supportive for stocks? Fed hiking into strong employment is certainly better than the Fed hiking into slowing employment market with high inflation.
• Not in a world where market(s) are still sorting central banks and the tide is heading out and real rates are still repricing.

Does 50bps in March make sense?

• Expectations for CPI are for higher headline again.
• 50bps seems an unnecessary risk, but markets will keep searching for the level of the Fed put and that 50bps debate will make that tough.

UK

Post-BoE [Thursday]

• BoE year-end 2022 pricing is now probably a fade. They revised down growth going forward to below trend.

Europe

• The ECB had been the voice of Germany until Lagarde took over. Now it is the most dovish central bank in the world. How politically sustainable is that? Are German savers not protesting?
• From their standpoint this is not crazy. After a decade of deflation, they cannot panic with 2.3% German Core Inflation.
• The savers do not care about a statistic, they care about how it feels. Plus, I have not heard of anyone complaining about things getting cheaper in any case. So, politically yes inflation is a problem, deflation not so much.

Post-ECB

• The doves will now capitulate. They need to rush in APP taper.
• Lagarde is very hawkish, they can hike rates.
• Periphery should sell off more than Bunds.

Can they hike before December if sequencing stays the same?

• They have pushed back a few times against the sequencing changing. It is likely they stop QE in Q3 so they can hike at year-end. Net issuance will rise again. DMOs would have to rush to issue as much as they can before March.
• Pricing even a small hike in July is crazy. It is the best short. It means QE ends in May, lots of issuance left uncovered by the ECB.

Will European demand falter?

• The periphery is in a bad shape here. Macro-wise they are okay, but the ECB is aiming at lower demand.
• We should be careful to equate Fed or ECB hikes with ‘lowering demand.’ At this stage of the rate cycle, we are still in an unnecessarily super-easy policy zone and even 100bp of hikes will do nothing to contract demand.
• Possible yes. But if Italy is growing at 4%, way above potential, inflation is not coming down. They would need to tighten more.
• They would, but it will still take a lot of time before they admit it. Central banks do not solely target the link between output and inflation. The whole 2000’s for EMs there was a clear effort to enhance growth by reducing inflation uncertainty. It is not mechanical. DMs are in a similar phase now, for the first time in 25-30 years.

Can the Euro do well if the periphery suffers?

• Russia’s gas export contract with China is settling in Euro. Iran would like some of that too. Long-term demand for the Euro seems to be on the rise. Say ‘we’ need to find a trillion Euro to secure periphery debt sustainability, that is no longer so important, especially if this solidifies Europe’s reserve currency status.
• On the periphery, the issue is these countries are operating at 150-200% debt to GDP and much lower growth potential. So far, debt has not mattered because it was debt net of QE that was important.

Italy

• Draghi is looking to walk out; he just needs a good excuse. The current government does not seem likely to stay until 2023. And maybe the market suspects the same. It is striking the BTP is all about the ECB and not doing any better, even with Mario at the helm.
• The primary tasks of this parliament were to make sure that the president of the Republic was not an expression of centre-right. They did not want the election risk. With that now secured, by reappointing Mattarella for seven years, Draghi’s continuity at the government’s helm is less essential, and paradoxically early elections are now possible (with it, whatever anti-European winners it might produce).

Is there a chance Mattarella steps down after one to two years and Draghi still takes the presidency?

• This is what many politicians hope for. The issue is that Mattarella might feel he needs to serve the full seven years to preserve the head of state institution. That is, it was very controversial to extend a seven-year mandate anyway (not explicitly forbidden, but it raised a few eyebrows) and it would be the second time in a row.

Are BTPs crashing?

• BTPs are not crashing. They are widening out of a level that is crazy. At 200bps you can consider this question again.

Japan

Is the BoJ (the last non-pivot) standing?

• The BoJ pivot might be some time away – the most realistic pivot spot is probably the 28 April BoJ meeting. By then we will have the April CPI, which is likely to rise after last year’s last large reduction in mobile phone fees drops out.

China

Risks of KWEB vs QQQ [Trade ideas for reasoning of trade]

• The risk, if anything, is a general one on the regulatory US side, not particularly to Variable Interest Entities (VIE) structures. The regulatory risk on the Chinese side is still there, but again, it is not with the VIE structures.

Some of these Chinese companies have large amounts of cash on their balance sheet. Could they just buy back US listed shares?

• There should not be anything stopping them from doing this. Some of the big names (BABA, Tencent, JD.com etc) have been doing buybacks, but the shares were on their Hong Kong listings.
• For a Chinese company, who will be forced to delist in the US and relist in Hong Kong or Singapore, what is the upside in buying back shares owned by American or Western investors? Why not let it go to zero, similar to what is happening with the foreign-currency real estate bonds from Evergrande et al.
• That is the Armageddon scenario, if you believe they will be forced to delist. If it happens, it is more likely it will be on the back of the US regulators than the Chinese ones. It feels unlikely.
• It is very unlikely that Chinese corporates will be allowed to share all the (accounting) details that the US wants to see. A high percentage of companies will not be able to comply.
• As far as US regulations are concerned, the VIEs were designed specifically with US accounting rules in mind – they are already recognized by GAAP. Most large Chinese ADRs disclose the VIEs in their filings to the SEC (even that is not a requirement). VIEs are also relevant to Hong Kong, and there are even VIEs in Mainland China where there are less disclosure requirements companies to VIEs in the US. So, on the Chinese regulation side, they essentially approved the VIE structure last year.
• But, as mentioned earlier, it is the US regulations that China is unlikely to allow its corporates to abide by.
• That is certainly the risk. But again, China ADRs are in so many ETFs owned by so many retail investors (who have no clue they even own Chinese stocks, let alone VIEs) that it is extremely unlikely that such a scenario unfolds on the regulatory side – the lawsuits and compensation the ETF providers will have to pay will be large – it is probably even a systematic risk.

DIDI delisting from the US and relisting in Hong Kong could be a case study?

• If DIDI is an example, that is a shipwreck. IPO at $14 now at $3.
• It is more about the process than the price of doing such.
• The gap between what the US wants and what China can give is very wide. The market is starting to realise this gap and the clock is ticking (two years to the deadline, but some in DC want to cut the deadline by a year). There is no process for delisting yet. No one even knows how DIDI plans to do this. Some say DIDI will make US investors whole at the initial IPO price of 14, before delisting. This is highly unlikely with the spot price at 3. Others say DIDI will give Hong Kong share equivalent to US shares to each investor. But that is not straightforward as many investors in the US cannot take Hong Kong shares.

Trade Ideas

• Short GBP [Thursday]. BoE growth revisions.
• Long EUR/GBP [Thursday]. Buy any dips, there are large EURX shorts in G10 to be unwound.
• Short EUR/JPY [Thursday]. Risk not happy.
• Long KWEB vs Short QQQ [Thursday].It is a high-octane version of CQQQ vs QQQ – both are a countertrend trade. But not exactly clear if there is a trend. A few false breaks last year.
• Long USD/CNH [Monday].

Interesting Reads

Reads

• Thread on pushing back against rising ECB rates expectations
• The Economics of Hosting the Olympic Games | Council on Foreign Relations

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)