- Fed, foreign governments, commercial banks all stepping back
- More pain for bond investors may be in store amid buyer void
The top players in the $23.7 trillion US Treasury market are retreating everywhere you look. The majority of those who were once lined up to purchase US government debt, including Japanese pensions, life insurers, foreign governments, and US commercial banks, have since backed off. And of course there is the Federal Reserve, which accelerated its plan to sell Treasuries off its balance sheet a few weeks ago and is now doing so at a rate of $60 billion per month.
Although the impact would be felt, there probably wouldn’t be much cause for concern if one or two of these typically reliable sources of demand left. But for all of them to do so at once is unquestionably a cause for worry, particularly after the uncharacteristically high volatility, declining liquidity, and lacklustre auctions of recent months.
Market observers conclude that even though Treasuries have fallen this year to their lowest level since at least the early 1970s, more pain may be in store until fresh, reliable sources of demand appear. Furthermore, it’s terrible news for US taxpayers, who will ultimately be responsible for paying for increased borrowing rates.
“We need to find a new marginal buyer of Treasuries as central banks and banks overall are exiting stage left,” said Glen Capelo, who spent more than three decades on Wall Street bond-trading desks and is now a managing director at Mischler Financial. “It’s still not clear yet who that will be, but we know they’re going to be a lot more
Undoubtedly, throughout the previous ten years, many people have anticipated collapses in the Treasury market, only for purchasers (and central bankers) to intervene and stabilize the market. In fact, the brief gain in Treasuries last week may only be the beginning if the Fed shifts away from its aggressive policy bent, as some are betting. Analysts and investors, however, assert that this time is likely to be very different because the fastest inflation in decades is impeding officials’ ability to soften policy in the near future.
Unsurprisingly, the largest loss of demand is due to the Fed. In the two years leading up to early 2022, the central bank’s debt holdings more than doubled to exceed $8 trillion.
If policymakers persist with their present roll-off plans, the total, which includes mortgage-backed securities, may drop to $5.9 trillion by the middle of 2025, according to projections from the Fed.
Even if most people would agree that reducing the central bank’s market-distorting power is beneficial in the long run, for investors who have become accustomed to the Fed’s disproportionate presence, it is a sharp turnaround.
“Since the year 2000, there has always been a big central bank on the margin buying a lot of Treasuries,” Credit Suisse Group AG’s Zoltan Pozsar said during a recent live episode of Bloomberg’s Odd Lots podcast.
Now “we’re basically expecting the private sector to step in instead of the public sector, in a period where inflation is as uncertain as it has ever been,” Pozsar said. “We’re asking the private sector to take down all these Treasuries that we are going to push back into the system, without a glitch, and without a massive premium.”
However, market anxiety would be much reduced if it were only the Fed changing its mind about its long-forecasted balance-sheet runoff, unfortunately this is not the case.
Giant pension and life insurance organizations from Tokyo have virtually been locked out of the Treasury market due to prohibitively high hedging expenses. Even though nominal rates have surged beyond 4%, yields on US 10-year notes have fallen deep into negative territory for Japanese buyers who pay to have currency swings removed from their returns.
The dollar has increased by more than 25% this year vs the yen, which is the biggest in Bloomberg statistics going back to 1972as a result Hedging prices have risen in lockstep with this increase.
For the first time since 1998, Japan intervened to defend its currency in September, as the Fed proceeded to raise rates to combat inflation above 8%. This sparked concern that Japan may eventually need to start selling its stockpile of Treasury bonds in order to further support the yen.
It’s not just Japan, either. In recent months, nations all over the world have been reducing their foreign exchange reserves in an effort to defend their currencies against the rising dollar.According to data from the International Monetary Fund, central banks in emerging markets have actually reduced their stocks by $300 billion this year, indicating that the demand from a group of price-insensitive investors who typically invest at least 60% of their reserves in US dollars will therefore be minimal at best.
Over the past ten years, others have stepped in to fill the void left by one or two significant Treasuries buyers who appeared to have backed off. According to Jay Barry, a strategist with JPMorgan Chase & Co., that is not what is happening this time around.
As the Federal Reserve’s tightening of policy takes reserves out of the financial system, demand from US commercial banks has diminished. According to a study by Barry last month, banks bought the least quantity of Treasuries in the second quarter since the latter three months of 2020.
“The drop in bank demand has been stunning,” he noted. “As deposit growth has slowed sharply, this has reduced bank demand for Treasuries, particularly as the duration of their assets have extended sharply this year.”
It all adds up to a bearish undertone for rates, Barry added.
The Bloomberg US Treasury Total Return Index has lost about 13% this year, almost four times as much as in 2009, the worst full year result on record for the gauge since its 1973 inception.
Yet as the structural support for Treasuries gives way, others have stepped in to pick up the slack, allbeit at higher rates. “Households,” a catch-all group that includes US hedge funds, saw the biggest jump in second-quarter Treasury holdings among investor types tracked by the Fed.
Since yields are at multidecade highs and there is a possibility that Fed policy tightening may cause the US to enter a recession, some people believe there are compelling reasons why private investors should find Treasuries attractive right now.
“The market is still trying to evolve and figure out who these new end buyers are going to be,” said Gregory Faranello, head of US rates trading and strategy for AmeriVet Securities. “Ultimately I think it’s going to be domestic accounts, because interest rates are moving to a point where they’re going to be very attractive.”
Large surplus savings holdings in US banks earning next to nothing, according to John Madziyire, a portfolio manager at Vanguard Group Inc., will cause “people to transfer into the short-end of the Treasury market.”
“Valuations are good with the Fed getting closer to the end of its current hiking cycle,” Madziyire said. “The question is whether you are willing to take duration risk now or stay in the front-end until the Fed reaches its policy peak.”
However, most people believe that the environment favors higher yields and a more volatile market. While a metric of market depth recently hit the worst level since the start of the pandemic, a measure of debt-market volatility rose in September to the greatest level since the global financial crisis.
“The Fed and other central banks had for years been the ones suppressing volatility, and now they’re actually the ones creating it,” Mischler’s Capelo said.