The author is an analyst of NH Investment & Securities. He can be reached at email@example.com. -- Ed
Despite an aggressive monetary policy response, the Libor-OIS spread is still widening, which implies that a liquidity crisis is in play. Upcoming economic indicators should mark the beginning of confirmation of a crisis in the real economy. Believing that it is too early to worry about a QE-sparked yield uptrend, we continue to advise buying treasuries.
Liquidity crisis in play
The current crisis unfolded in the following order: 1) a real economy recession that started with Covid-19; 2) a credit crisis derived from a plunge in oil prices; and 3) a liquidity crisis. Meanwhile, policy actions have emerged in reverse order. Last week, the Fed made commercial MBS eligible for QE purchases, and it reinitiated unlimited QE. As a result, repo yields have remained stable despite end of quarter funding needs. But, the Libor-OIS spread is continuing to expand rapidly, a development which implies that a liquidity crisis is in play.
The Fed also announced the purchase of IG corporate bonds via a special purpose vehicle. But we note that 60% of energy firms are not of investment grade. And, purchase of strategic petroleum reserves was excluded from the massive US fiscal stimulus measures. Given that an oil price rebound looks a far way off, the credit crisis has yet to be resolved. Also, upcoming indicators are to mark just the start of a confirmation of an economic downturn. The US’s number of initial jobless claims soared from 280,000 to 3.28mn in a single week. With the crisis is still ongoing, US TB yields will need to stabilize at a lower boundary before the economy can bounce back. Thus, US TB yields are to keep trending downwards for now.
We do note that there have been many past cases where Fed’s QE served as a trigger for long-term yield uptrend, based on the logic that the liquidity supplied by QE programs will eventually push up inflation. But, the oil price has dived 44.8% y-y. Demand-side inflationary pressure is also weak. If inflation concerns are muted, unlimited QE should provide a favorable supply-demand environment.
BOK’s remaining card: Greater purchasing of KTBs
On Mar 26, the BOK said that it would provide liquidity through unlimited RP purchases for three months. Although this action is of different nature from QE in advanced countries (where they declare purchases of long-term treasuries), the BOK’s actions should ease: 1) credit market concerns; and 2) end-of-quarter funding-sparked strains in the short-term market (which have caused long-term KTB yields to trend upwards despite economic fears, weakening the price formation process). The current policy response is to light the way towards finding the right spread between KTB yields and the benchmark rate.
Even after unlimited repo purchases, the BOK will still have left to it the policy option of expanding its amount of KTB purchases. During the 2008 financial crisis, the balance of BOK-held KTBs held upped 42%. Given an overall lack in tax revenue (eg, decreased corporate tax inflow), the BOK will likely support aggressive fiscal spending by buying KTBs. But if so, there will be an easing in supply-demand burden, a unique risk in domestic bond market. With the unique risk abated, KTB yields should fall in line those in major economies. Against this backdrop, we continue to recommend going long on KTBs.