Crash Up
The coming months are looking to be very positive for equity markets as rate cuts are expected to occur in the context of significant deficit spending. In the modern financial system, Treasuries are money like assets so deficit spending is comparable to a form of money printing. As interest rates decline, Treasuries become less attractive and investors tend to rebalance into riskier assets. Given the size of the fiscal deficit, investor portfolios are growing significantly so rebalancing can meaningfully increase demand for equities at a time when the supply of equities has been structurally shrinking. This post reviews the moneyness of Treasuries, notes the potential for a surge in risk assets, and suggests the bond market will eventually check the advance after a sharp rally upwards.
The Other Printer
Deficit spending creates a Treasury security, which increases the purchasing power of the private sector. When an investor buys a Treasury security, he sends cash to the government and receives a Treasury security in return. The government takes the investor’s money and spends it, so the cash ends up right back into the account of someone in the private sector. Despite holding less cash, the investor is able to easily monetize his Treasury security by selling it in the very deep Treasury cash market or borrowing against it in the even deeper Treasury repo market. Treasuries are thus a liquid, cash like asset. At the end of the day, the private sector holds more purchasing power because it holds more Treasury securities and its cash holdings are unchanged.
In the absence of a crisis, investors tend to sell Treasuries for riskier assets as interest rates decline. In theory, a Treasury’s yield acts as an opportunity cost that encourages investors to hold them over equities and other financial assets. When interest rates decline, Treasuries become less desirable relative to other assets. During the zero interest rate era, Chair Bernanke explicitly noted that an intended effect of QE was to create a wealth effect by lowering interest rates and prompting a rebalancing of portfolios into risk assets. The same rebalancing can also occur when interest rates decline from expectations of future rate cuts. A higher quantity of Treasuries held by the private sector potentially implies a stronger rebalancing effect. Treasuries outstanding have increased significantly and is projected to grow at a historically high rate.
Equity Scarcity
Equities prices may surge as demand for equities will likely increase through portfolio rebalancing even as the supply of equities has structurally declined through share buybacks. The supply of equities has been steadily declining for over the past two decades as share buybacks and mergers have outpaced equity issuance. Non-financial corporations appear to prefer spending cash on stock buybacks, which is associated with a rise in share prices. For example, Apple reduced its shares outstanding by 38% over the past 10 year and also saw significant price appreciation. The structural decline in equity shares outstanding may make equity prices more sensitive to increases in demand.
Large fiscal deficits combined with future rate cuts will likely lead to significant demand for equities. The wealth distribution of the U.S. is heavily concentrated, suggesting that newly printed Treasuries ultimately end up in the hands of a small group of people. At the same time, the attractiveness of Treasuries is decreasing with the expectation of rate cuts. The market has priced in 125bps of cuts in 2024after hearing Governor Waller suggest cutting rates due to moderating inflation. This may encourage wealthy investors to rebalancing their rapidly growing portfolio out of bonds and into other assets like equities. The intersection of a structural decline in equity supply with a structural increase in demand suggests the potential for significant upward price pressure.
Bond Market Brake
An on-going rally is likely not going to deter future cuts, but the rally could be checked by market forces. The Fed’s mandate is full employment and price stability, with financial conditions a means of achieving the two. The clearly slowing U.S. economy directly touches the Fed’s mandate, while rising equity markets do not. The link between financial conditions and economic activity has just not been strong this cycle, with growth above trend despite aggressive hikes. But the link between significant issuance and the level of yields has been strong, with the market showing signs of difficulty in digesting endless Treasury issuance. The equity rally may persist until the bond market wakes up and realizes we are truly in a different era. That should gradually become more apparent with each auction over the next 2 -3 months.