Treasury buybacks - what does it mean?

 

Treasury Secretary Bessent announced a Treasury buyback program, an increase in an existing program, amid much market discussion about its objectives and what it means. Investors should note that this does not change the size of the deficit or the Treasuries outstanding. It may change the debt’s composition and will affect the spread between on-the-run and off-the-run bonds. For the Treasury market to function well, off-the-run bonds need strong liquidity, and this should be the main focus of this program.

We are concerned with the plumbing of the Treasury market. Primary dealer capital is constrained under current bank regulation, so dealer capital is out of balance relative to trading and outstanding debt. Dealers must maintain high leverage, and if capital is insufficient, their ability to maintain orderly markets is compromised. 

The unstated and overlooked issue is the potential problems in the plumbing of the Treasury market. Actions are being taken to constrain the potential for a liquidity crisis. The chief bond salesman - the Treasury secretary - is not going to talk about this issue.

Treasury buybacks - A history

The Treasury announced an increase in its Treasury buyback program from $2 to $4 billion per operation. This is not the first time buybacks have been used to support the Treasury market, yet this action suggests plumbing problems in the Treasury market. Past buybacks have focused on ensuring more Treasury market liquidity. We expect the same for this program, but it also means the Treasury will be an active liquidity provider in the Treasury market. 

Short-term trend trading and liquidity - stay away from small tick contracts

 

The paper, “Is Trend Still Your Friend: A microstructural account of the demise of short-term trend-following”, is important research on why trend-following may not work over short horizons. While trend-following seems to span time, there are exceptions. Since 2009, there has been no profit to be had from short-term trend trading. This paper documents the break in short-term trend trading and finds a reasonable explanation. 

The paper tests four different explanations: 1. capacity constraints, 2. market electrification, 3. a change in CTA order flow interactions, and 4. microstructural changes. The authors find that the first three cannot explain the differences, but the volatility-normalized tick size can explain the change in profits. The trend profits fell on small-tick contracts but remain intact for large-tick contracts. Trend signals trigger directional trades. The market impact of these trades reinforces price movement. This feedback loop requires aggressive execution at reasonable costs, but it also causes market makers to withdraw from the trend, especially for small-tick contracts. Trend-following becomes unprofitable. Stick with the large ticks if you want to trade short-term. 

Japan and the big carry trade

 

The yen carry trade has existed for decades. Borrow in cheap Japanese funding markets, sell yen, and then buy the currency of a high-yielding market in some other currency. Of course, hedging and risk management add layers, but the overall strategy is straightforward. Everything works until it does not, because of two things: 1) rates in Japan increase relative to the rest of the world, the yield spread falls; and 2) the yen appreciates, which can wipe out the gains from the spread differential. Now the Bank of Japan is raising rates, and the Finance Ministry is intervening in the yen markets to stop the currency slide. The net effect. is that less money will flow into foreign-yielding markets versus Japan. This will mean global rates will adjust higher.

Global bond markets are changing, and old sources of funding will no longer be available to borrowers. We can expect higher equilibrium real rates. We cannot say what the new rates will be, but the old environment is not working.