Rates Spark: Lots to get excited about… next week

It's been one of those weeks so far. A hugely impactful start on the inauguration of President Trump, but lacking on material impulse for markets, partly as it's not clear what to take seriously or what not. Data releases have been somewhat meh too. And it does not get much better on Thursday, as US jobless claims feature (expect an ongoing match in the 220k area, indicative of an ongoing firmish labour market).

The big one is next week in the guise of the core PCE data. For Treasury bulls, if this number comes in at 0.2% (or better) that would be a clean sweep of core inflation readings turning the corner again, this time in a positive-for-bonds direction. Even though the year-on-year rate would remain troublingly high (2.8%), base effects for the subsequent number of months would ratchet that YoY rate down to the sub-2.5% area. That, together with the ongoing upsizing in duration exposure from mutual funds is why we remain tactically bullish.

So why the sad bear face thereafter? We remain apprehensive of the tariff effect on US prices on reprisals, of any new tax cuts that might be implemented, and the elephant very much remains in the room (whisper it – the size of the US fiscal deficit, and another upcoming set of re-funding figures to refocus the market on it).

The minutes from the December meeting noted that usage of the overnight reverse repo facility remained on a declining trend, reflecting money market fund reallocation to Treasury bills and private-market repo, which offered slightly more attractive market rates. This occurred against a tightening in market repo conditions, and continued increases in net Treasury bill issuance. At that meeting, the Fed also reduced the rate it pays at the reverse repo window by 5bp, back to flat to the funds rate floor. This adds to the attraction of market repo, and should correlate with further falls in use of the reverse repo window. Our view is usage of the reverse repo window will ultimately fall towards zero, barring some temporary spikes around month end.

The Fed may or may not comment on the above. Also interesting to see whether the Fed comments on the resurrection of the debt ceiling since 2 January 2025. While it’s too early to expect a material market focus on it, the technical aspects of it are impactful. For as long as the debt ceiling remains in place and the Treasury employs extraordinary measures to avoid breaching it, there is a tendency to spend down the cash balances that it holds at the Fed. As these get spent down, they add to reserves in the system which in turn acts to counter the tightening effect of the ongoing quantitative tightening (QT) programme. In effect, hitting the debt ceiling forces the Treasury to be a net supplier of liquidity to the system.

Despite these complications, the Fed may well lay the groundwork for ending QT at some point in 2025. This is the case as excess liquidity (which we define as bank reserves plus reverse repo balances) is likely to hit levels that the Fed would prefer not to go below from the middle of 2025 onwards, partly depending on how the debt ceiling saga evolves. The key number here is US$3tn for reserves, representing about 10% of GDP. We are currently at US$3.5tn. So we’re comfortable. At the same time, the reverse repo balance is running at US$125bn, and if that were to hit zero, then we’d hit some degree of tightness. That’s close, as QT is running at US$60bn per month. QT may have to end by mid-2025 based off a simple extrapolation of this.