- How to understand the short-term changes in U.S. bonds and the U.S. dollar? The upward movement of U.S. bond yields and the U.S. dollar index on the day the Fed resolution was announced was mainly due to the Fed itself. Although the Fed did not change its easing stance, it quickly and effectively returned liquidity from the bond market to the Fed’s overnight market, easing the impact of early liquidity on the bond market, while also releasing expectations of future tightening. As a result U.S. bond yields and the dollar index both moved up. The previous overnight reverse repo rate was 0, which was completely unattractive to market funds, unless there was really no asset allocation, or forced by regulatory constraints, the market would deposit funds in the Fed’s overnight market. The use of overnight reverse repo before the resolution is still $500 billion, the U.S. debt short-term constantly close to 0, and there has been a substantial breakthrough in the market funding rate 0 lower limit, indicating that the U.S. debt market is too flooded with liquidity, and there is still a lot of money not back to the overnight market. The Fed could care less about the ups and downs of U.S. debt, but it needs to protect its commitment to the 0 interest rate floor. The resolution to raise the reserve rate and the overnight reverse repo rate by 0.05% each is actually meant to guide excess funds from the bond market back to the overnight market, which in turn has the effect of protecting the 0 interest rate floor and providing a threshold for funding rates. After the announcement of the Fed resolution, overnight reverse repo usage surged further to $700 billion, but the rapid upward movement in funding rates and short-term U.S. bond yields suggests that instead of a further flood of U.S. domestic liquidity, it was effectively repatriated to the Fed overnight market.
Why did U.S. bond yields take a sharp turn for the worse the day after the Fed resolution was announced (June 18) while the dollar accelerated to the upside?
First, it is clear that the reason was certainly not a further flood of liquidity in the U.S. bond market, given that excess liquidity had been better rolled back into the overnight market. But the flood of liquidity is still objective.
Moreover, on June 16, after the mid-month issuance of medium- and long-term U.S. debt, the balance of the TGA account was $748.4 billion, compared to $737.6 billion on June 9 instead, also indicating that the growth of overnight reverse repos was not caused by the TGA account drain. Thus a further flood of liquidity cannot be used to explain the sharp turnaround in US bonds.
Second, multiple features suggest that the cause was the cross-border arbitrage triggered by the BOJ resolution’s over-expected easing resolution.
The two most critical factors influencing cross-border arbitrage are domestic and foreign currency appreciation expectations and domestic and foreign currency spreads, respectively. Due to the BOJ’s yield curve control, the rapidly rising U.S. bond yields in the previous trading day already provided a large U.S.-Japan spread, and the BOJ resolution provided expectations of an appreciation of the dollar-yen exchange rate. For smart Japanese money, the BOJ’s over-expected easing certainly provides a very large arbitrage space.
Japanese institutions to buy U.S. bonds need to exchange into U.S. dollars before buying U.S. bonds, so the volatility will be transmitted from the exchange rate to U.S. bonds, and will be expressed as the dollar index upward, while U.S. bond yields downward. In March, when the Fed kept its easing stance unchanged and the BOJ continued to ease, there was a similar change in the dollar and U.S. bond yields.
After June 21, why did U.S. bond yields rebound while the dollar fell?
Because cross-border arbitrage comes and goes quickly. What the post-Japanese BOJ resolution offered was risk-free arbitrage space, which can disappear quickly when driven by transactional behavior. When the Japanese funds leave the market, the overshooting U.S. bonds and the dollar will naturally return to the pivot.
Evidence one, the dollar index and the dollar-yen exchange rate are moving in opposite directions. After the BOJ resolution (June 18), the dollar moved down against the yen and the dollar index moved up, and after June 21, the dollar moved up against the yen and the dollar index moved down.
Exhibit 2, Japanese stocks moved in the opposite direction of U.S. bond yields. After the BOJ resolution (June 18), the Nikkei 225 plunged and U.S. bond yields moved down, and after June 21, the Nikkei 225 rebounded to largely recover lost ground and U.S. bond yields moved up.
Both of the above evidence point to the fact that after the BOJ resolution, Japanese funds flowed massively to the U.S. bond arbitrage, and after June 21, these funds have largely returned to the Japanese market.
- Is the short-term correction in U.S. bonds and the U.S. dollar over? As mentioned earlier, the cross-border arbitrage of Japanese funds is basically over, so we will not go into details. However, the flood of US interbank liquidity has only been temporarily rolled back into the Fed’s overnight market and has not materially changed the extremely abundant supply of funds in the bond market. When is it likely to end? There is a market view that the recovery in U.S. bond supply will also end the adjustment in U.S. bonds, given that the reduction in net financing in May directly triggered the acceleration of the U.S. bond retreat in June. Is this really the case? We believe that this view has some merit, but clearly fails to understand the operational intentions of the U.S. Treasury. If we look at the specific U.S. bond issuance plan, we can see that the U.S. Treasury’s operation on TGA account balance management and Treasury bond issuance cannot be viewed separately. According to the issuance plan announced by the U.S. Treasury, medium- and long-term U.S. debt issuance in June was concentrated at the beginning and middle of the month, while the issuance of short-term U.S. debt was relatively scattered. As a result, TGA account balances were higher in the first and third weeks of June, and significantly lower in the second week. Subsequent peaks in the supply of U.S. debt will occur in late June and mid-July, respectively. However, compared to June, the proportion of medium- to long-term US debt issued in the subsequent period has not changed much and the total amount is largely comparable. Therefore, the probability of U.S. debt asset shortage is just a means for the U.S. Treasury to cooperate with the release of TGA account balances. It is important to know that, on the one hand, although accelerating the issuance of U.S. debt can alleviate the asset shortage, it will also push up the TGA account balance, which will in turn increase the difficulty of subsequent suppression of the TGA account balance. On the other hand, even adjusting the maturity structure of net financing of U.S. bonds can only temporarily adjust the curve structure of U.S. bonds, and the help to ease the pressure of TGA account balance release is relatively limited. Because raising net financing of medium- and long-term U.S. bonds would necessitate a corresponding reduction in net financing of short-term U.S. bonds, the result would be the same flood of liquidity. In order to suppress the TGA account balance, while reducing the impact of funding volatility on the market, for the U.S. Treasury, the current relatively reasonable arrangement may only reduce the net financing of short-term U.S. debt, and then further reduce the net financing of medium- and long-term U.S. debt. Therefore, in July 31 TGA account 450 billion U.S. dollars before the arrival of the pressure limit, the market will not wait for the accelerated recovery of the U.S. debt supply, the flood of market liquidity will continue, the Fed will probably only be able to continue to transfer liquidity through the overnight reverse repurchase tool. And after the July 31 deadline, in order to enhance the TGA account balance, the U.S. bond supply will naturally accelerate the recovery. Overall, although the U.S. bond market is still flooded with liquidity, the flooded liquidity is difficult to be reversed before July 31. Therefore, we judge that the short-term adjustment of the U.S. dollar may be nearing the end and the adjustment of U.S. bond yields will also come to an end. 3. Summary How to understand the short-term changes of U.S. bonds and the U.S. dollar? The upward movement of U.S. bond yields and the U.S. dollar index on the day the Fed resolution was announced was mainly due to the Fed itself. Although the Fed did not shift its easing stance, it quickly and effectively returned excess liquidity to the overnight market through technical adjustments, easing the impact of liquidity on the bond market, while also releasing expectations of future tightening, so U.S. bond yields and the U.S. dollar index both moved upward. The sharp turnaround in U.S. bond yields and the acceleration in the dollar index after June 18 was mainly attributed to short-term cross-border trading arbitrage caused by the BOJ’s resolution for further easing. With the Fed releasing tightening expectations, the BOJ’s further easing pushed up expectations of an appreciation of the dollar-yen exchange rate, which, combined with the rapid widening of the U.S.-Japan spread, triggered cross-border arbitrage by Japanese funds. But cross-border arbitrage comes and goes quickly, the arbitrage space quickly wiped out, after June 21, with the outflow of funds, overshooting the U.S. debt has rebounded, the dollar has also fallen back. Is the short-term adjustment of U.S. bonds and the dollar over? The current cross-border arbitrage of Japanese funds is basically over, but the flood of liquidity has only returned to the Fed’s overnight market and has not changed the extremely abundant supply of funds in the U.S. bond market. However, the flood of domestic liquidity in the U.S. will also be difficult to reverse before the 731 deadline. According to the change of TGA account balance and the U.S. Treasury Department has announced the issuance of U.S. debt until July 31, it is also difficult to materially transform the liquidity flood in the U.S. debt market before the 731 deadline. Therefore, we judge that the adjustment of the dollar may be nearing the end and the adjustment of U.S. bond yields will also come to an end. Looking ahead to the dollar, referring to the situation in early March when the BOJ stepped up easing while the Fed stayed put, the highest adjustment was close to 140 basis points, corresponding to the dollar index ceiling of 91.9, which is currently very close. Looking ahead to the U.S. debt, taking into account the extreme abundance of domestic liquidity in the United States has gone, the impact on the bond market has eased, the current market has been in the vicinity of 1.50% temporarily sounded gold, also basically reflects the current attitude of the market.