Photo: Bloomberg TV
By now, “fiscal cliff” should be a familiar term. The concept has inspired spin-offs like the “monetary cliff” and the “deposit insurance cliff,” among others.Now, Societe Generale economist Aneta Markowska is warning of another cliff – the dangers of which constitute a 75 per cent drop in new securities in the world’s biggest bond market in 2013. One might expect this cliff to be the most deflationary of them all.
In a note entitled The “cliff” facing US Treasury supply, Markowska writes:
At the very minimum fiscal policy will shave 0.8% from GDP next year. This is a result of payroll tax hikes and spending caps which have little chance of being reversed under any election outcome. Our central scenario also assumes that the planned spending cuts will not be reversed and that Bush tax cuts will expire for the wealthy. Combined, these measures would reduce the deficit – and thus Treasury issuance – by more than $300bn in FY’2013. We project net new Treasury supply of $821bln in the fiscal year that began on October 1, down from $1,126bn in FY’2012.
Net Treasury supply available to investors could be further reduced by Fed buying. We expect that the Fed will continue to buy long-dated Treasury securities beyond the Maturity Extension Program which expires at the end of the year. Maintaining the $45bn/month buying pace through 2013 would reduce net supply of Treasury paper by a further $540bn. Given our fiscal assumptions, this would leave only $281bn of new Treasury debt available to investors. This constitutes a 75% drop from Fed-adjusted supply in FY’2012. In contrast, if the entire cliff were to be avoided, the Fed would likely end its flow-based QE earlier than we expect and the net supply would remain close to $1tn. However, this is not a likely scenario in our view.
Here’s what that cliff looks like after you net out the Fed purchases Markowska mentioned:
Photo: Societe Generale
Why is this such a big deal?
As can be seen in the chart above, we already rode over this cliff – in 2011. At the same time last year, not just the supply of Treasuries, but the supply of AAA-rated bonds around the world was shrinking.
BofA Merrill Lynch strategist David Woo broke this down in a recent note to clients:
In August 2011, Japan was downgraded by Moody’s from Aa2 to Aa3; two months later, Italy was downgraded from Aa2 to A2, Spain from Aa2 to A1 and Belgium from Aa1 to Aa3. The percentage of sovereign bonds with Moody’s credit rating of Aa2 or above in the Merrill Lynch Global Sovereign Market Plus fell from 93% at the end of July to just 53% by year-end (Chart 8). A sudden decline in the stock of highly rated government bonds might have reduced the yields investors are willing to accept for buying such bonds.
Here is Woo’s chart showing the drop-off in 2011, when the universe of highly-rated bonds was slashed dramatically:
Photo: BofA Merrill Lynch
The major implication, then, of this “cliff” in U.S. Treasury supply is that it will further shrink the amount of safe assets – necessary for use as collateral in financial transactions – available to the market.
Brockhouse Cooper strategists Pierre Lapointe and Alex Bellefleur posed the question back in January – what happens if there is not enough high quality collateral to go around?
The answer: deflation.
From the Brockhouse note:
So, what are the consequences of this collateral shortage? The first one, as suggested by the IMF, is a contraction of credit. That process is underway in most developed economies, including the United States where credit as a percentage of GDP has been contracting for a number of quarters, and will continue in the coming years.
Finally, the shortage of collateral is deflationary. The IMF estimates that in spite of repeated quantitative easing programs, global liquidity (M2 plus collateral use/re-use) remains below pre-2008 levels and some USD 5 trillion has vanished from the global collateral markets. As described above, this leads to credit contraction, less money creation and negative repo rates. These are all fundamentally deflationary developments.
The IMF paper the Brockhouse Cooper strategists mention is by Manmohan Singh, the IMF economist responsible for most of the Fund’s collateral and shadow banking-related research.
The paper, entitled Velocity of Pledged Collateral: Analysis and Implications, explains how a reduction in the supply of collateral has massive multiplier effects, and ultimately can bring about a figure like the $5 trillion cited above. It’s a must-read.
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