Bond investors may experience additional agony due to a buyer’s void.
The most prominent participants in the $23.7 trillion US Treasury market are retreating everywhere you look.
Most of those who were previously lined up to purchase US government debt, including Japanese pensions, life insurance, foreign governments, and US commercial banks, have since backed off. Of course, the Federal Reserve recently increased the rate at which it intends to sell Treasuries off its balance sheet to $60 billion per month.
Even though the impact would be felt if one or two of these typically reliable sources of demand left, there would probably be little cause for concern. But all of them doing so at once is unquestionably a cause for worry, particularly after the uncharacteristically high volatility, declining liquidity, and lackluster auctions of recent months.
Market observers conclude that even though Treasuries have fallen this year to their lowest level since 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 eventually be responsible for paying for increased borrowing rates.
Glen Capelo, a managing director at Mischler Financial who spent more than three decades on Wall Street bond trading floors, stated, “We need to find a new marginal buyer of Treasuries as central banks and banks generally are departing stage left.” “While it’s still unclear who that will be, we do know they’ll be much more price-conscious,”
Undoubtedly, many people have anticipated the Treasury market collapse throughout the past ten years, only for purchasers (and central bankers) to intervene and stabilize the market. The short gain in Treasuries last week may only be the beginning of the Fed’s shifts away from its aggressive policy bent, as some are betting.
Analysts and investors, however, assert that this time is likely to be quite different since the fastest inflation in decades is impeding policymakers’ capacity to soften policy shortly.
Unsurprisingly, the most significant loss of demand is due to the Fed. In the two years leading to early 2022, the central bank’s debt holdings quadrupled to almost $8 trillion.
If policymakers persist with their current 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, it is a sharp turnaround for investors who have become accustomed to the Fed’s disproportionate presence.
During a recent live broadcast of Bloomberg’s Odd Lots podcast, Zoltan Pozsar of Credit Suisse Group AG noted, “Since the year 2000, there has always been a major central bank on the margin buying a lot of Treasuries.”
When inflation is as unpredictable as it has ever been, “we’re expecting the private sector to step in instead of the governmental sector,” Pozsar said. We’re asking the private sector to remove all of the Treasury securities we want to reintroduce into the market smoothly and at no significant premium.
More: JPMorgan is concerned about who will purchase all the bonds.
Still, market anxiety would be much reduced if the Fed were the only entity to change direction, given its long-forecasted balance-sheet reduction.
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 purchasers 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 from 1972. 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 raised rates to combat inflation above 8%. This sparked concern that Japan may eventually need to start selling its stockpile of Treasury bonds to strengthen the yen further.
It’s not just Japan, either. In recent months, nations worldwide have been depleting their foreign exchange reserves to defend their currencies against the rising dollar.
According to data from the International Monetary Fund, central banks in emerging markets have reduced their stocks by $300 billion this year.
View more: World Currency Reserves Experience Record Drawdown of $1 Trillion
The demand from a group of price-insensitive investors who typically invest at least 60% of their reserves in US dollars would thus be minimal at best.
Over the last ten years, others have stepped in to fill the void left by one or two significant Treasuries purchasers 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.
Demand from US commercial banks has diminished as the Federal Reserve’s tightening policy takes reserves out of the financial system. 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.
He said, “The decline in bank demand has been astonishing.” “Bank demand for Treasuries has decreased as deposit growth has slowed substantially, especially since the duration of their assets has increased sharply this year.”
All of this combines to create a rate-bearish undertone, Barry continued.
Since its establishment in 1973, the Bloomberg US Treasury Total Return Index has lost roughly 13% of its value this year, about four times as much as it lost in 2009. This is the worst full-year performance on record for the gauge.
However, as the Treasuries’ structural underpinning breaks down, others have stepped in to fill the void, albeit at higher rates. Among the investment categories the Fed tracks, “Households,” a catch-all category that includes US hedge funds, experienced the most significant increase in second-quarter Treasury holdings.
Since rates 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 appealing right now.
According to Gregory Faranello, head of US rates trading and strategy at AmeriVet Securities, “the market is still trying to adapt and find out who these new end customers are going to be.” Ultimately, I believe domestic accounts will prevail since interest rates are on the verge of reaching a very alluring level.
Large surplus savings holdings in US banks earning close 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.”
Values are strong as the Fed approaches the conclusion of its current rate increases, according to Madziyire. The key decision point is whether you want to take on duration risk right away or wait until the Fed achieves its policy high.
However, most people believe that the environment favors higher yields and a more volatile market. While a metric of market depth recently touched the lowest level since the start of the epidemic, a measure of debt-market volatility rose in September to the greatest since the global financial crisis.
According to Capelo of Mischler, “the Fed and other central banks have for years been the ones controlling volatility, and now they’re the ones causing it.”