As the Trump administration and Congress deal with the economic implications of COVID-19, the government has unleashed a series of stimulus packages at unprecedented scale to help cushion the economic aftershocks to U.S. workers and businesses hit by the pandemic.
More specifically, Treasury has responded by issuing a massive amount of Treasury securities the effects of which I believe are going to continue to reverberate on yield curves for years to come, changing dynamics of pricing along the U.S. Treasury curve. What might this look like for investors and how can they position themselves to take advantage of this? With the freedom to commit capital to many of these mispriced opportunities and the ability to assume a role more traditionally played by banks and broker-dealers, hedge funds may offer an attractive risk-adjusted return in the rates space. More specifically, I believe that fixed-income relative-value hedge funds, which specialize in U.S. Treasury coupon arbitrage, swap spreads arbitrage and future basis arbitrage, can help take advantage of these opportunities.
By way of context, Treasury has stated it believes it will have to borrow up to $3 trillion in the second quarter alone; it already has issued more than $2.25 trillion in T-bills. In addition, Treasury has increased coupon auction sizes by multiple billions per coupon and will most likely continue this process throughout the year. We expect issuance for coupons to increase by more than 30% by year-end. Similarly, the new 20-year bond, which was expected to be roughly $12 billion in size, has been increased to $20 billion. The combination of these changes has significantly changed trading dynamics in the U.S. Treasury market. The ripple effects of these enormous fiscal injections can be seen in higher-than-otherwise-expected intraday volatility of absolute-yield levels as well as intraday and longer-term relationships of yield curve spreads.
One knock-on effect of the Treasury stimulus is that hedge funds and other non-dealer entities have an unprecedented opportunity to become more involved in the pricing and distribution process. Traditional broker-dealers don't necessarily have the capacity to completely underwrite the auction process, particularly at the margins. The reasons for this capacity gap date back to the structural changes in bank regulation and market-making activities made following the Lehman Brothers collapse more than 10 years ago, which led to a significant increase in non-dealer activity in the underwriting process. That process only accelerated in the last three months due to COVID-19. While the Federal Reserve has intervened to help market liquidity return toward pre-COVID-19 levels, the relative success of the intervention varies from asset class to asset class. While it may seem obvious that liquidity and bid/offer spreads for distressed corporates remain under pressure, many liquidity measures for even long-dated Treasuries have still not returned to pre-crisis levels.
With massive T-bill issuance, Treasury has relied on large money market funds to provide the cash to purchase Treasury bills in auctions alongside the typical dealer activity. These funds bought more than $265 billion in Treasuries in the first quarter alone, the highest pace in more than two years. Similarly, the process of issuing longer debt has become more volatile, generating larger movements in the Treasury segment around the issuance cycles.
Whether analyzing yield curve movements, relative-value opportunities or absolute-yield levels, one can see that the increased size of current auctions and expected size of future auctions have weighed on the market. Premiums for on-the-run Treasury securities, those most recently issued, have generally decreased as new issues have grown in size and the Fed's buying of issues has altered the availability of securities to borrow. Relative-value relationships such as swap spreads and break-even inflation levels as they relate to the issuance cycles have also shown more volatility. In addition, curve volatility has also increased as these new auction dynamics have unfolded. Greater volatility in U.S. Treasury security relationships provides traders with more opportunity to position relative-value trades around potential mispricings.
As these dynamics unfold here in the U.S., a similar pattern can be seen in many of the other G-20 countries. Large stimulus efforts and the subsequent issuance by governments has led to similar volatility in each relative sovereign space. As we see with increased fiscal spending in Germany and as a fourth stimulus package is discussed by the Trump administration and Congress, it is obvious these new issuance dynamics will only continue to increase their influence on yields, curve spreads and relative-value relationships.
With U.S. money market funds providing much of the needed funding for new, large issuance of T-bills, and hedge fund and other non-dealer entities becoming much more active in the underwriting and pricing process for Treasury coupon issuance, volatility in these relationships should continue to increase and should remain high for the foreseeable future.
In summary, fixed-income hedge funds can commit capital to take advantage of mispricings without capital constraints such as supplementary leverage ratio or liquidity coverage ratios or bank capital regulation that has limited the ability of banks to participate in these activities. Investors looking for a safe haven and a way to capitalize on the increased volatility should look to investment strategies such as fixed-income relative value that can help them ride the volatility wave.
EG Fisher is co-CIO at Mariner Investment Group LLC, New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.
