Biggest buyers turned away from Treasury bonds

The Japanese pension funds and life insurers, foreign governments and US commercial banks that once lined up to collect US government debt are now largely stepping back. And the Federal Reserve, which a few weeks ago ramped up plans to sell Treasury bonds from its balance sheet to $60 billion a month.

If one or two of these normally strong sources of demand were to fail, the impact, while noticeable, would likely not be of much concern. But for each of them, such a refusal is an undeniable source of concern, especially against the backdrop of unprecedented volatility, reduced liquidity and sluggish trading in recent months.

As a result, experts say, even though Treasuries have fallen the most this year since at least the early 1970s, there could be more problems until new, sustainable sources of demand emerge. It’s also bad news for US taxpayers, who will end up paying the price of rising borrowing costs.

“We need to find a new marginal buyer for Treasuries as central banks and banks in general are quietly disappearing from the scene,” said Glen Capelo, who has been trading bonds on Wall Street for more than 30 years and is now the managing director of Mischler Financial. “It’s not yet clear who it will be, but we know they will be much more price sensitive.”

Treasuries fell again on Tuesday in Asia. The 30-year US bond yield jumped nine basis points to 3.94%, the highest level since 2014, while the 10-year yield jumped seven basis points to 3.95%.

Bonds have experienced a record drop and increased volatility

Source: Bloomberg

Yes, many predicted the collapse of the Treasury bond market over the past decade, only for buyers (and central banks) to step in and support the market. In fact, if the Fed backs away from being aggressive, as some are betting on, last week’s short-lived rally in Treasuries could be just the beginning.

With the fastest inflation in decades preventing officials from easing policy in the near term, this time is likely to be different, analysts and investors say.

“Huge Prizes”

Unsurprisingly, the biggest loss in demand comes from the Fed. The central bank more than doubled its debt portfolio in two years, including early 2022, to over $8 trillion.

The Fed estimates that the amount, which includes mortgage-backed securities, could fall to $5.9 trillion by mid-2025 if officials stick to current plans to wind down purchases.

While most agree that easing the central bank’s market-distorting influence is beneficial in the long run, it is still a stark change for investors who are accustomed to the Fed’s excessive presence.

“Since 2000, a major central bank has always bought a large amount of Treasury bonds,” Zoltan Pozsar of Credit Suisse Group AG said on the Bloomberg Odd Lots podcast.

Now, “we are basically waiting for the private sector to intervene instead of the public sector during a period of highly uncertain inflation,” he added. “We’re asking the private sector to take all of these Treasury bonds that we’re going to put back into the system without hiccups and without huge premiums.”

However, if the Fed had simply reversed course to deliver the much-anticipated balance sheet cut, the market would have been far less concerned.

But it is not.

The exorbitant hedging costs essentially froze Tokyo’s giant pension and life insurance companies and forced them out of the Treasury bond market. Yields on 10-year US bonds have fallen below zero for Japanese buyers, who are paying out of their yields to rule out currency fluctuations, even as nominal rates jumped above 4%.

Hedging costs have risen along with the dollar, which has jumped more than 25% against the yen this year, the most since 1972.

As the Fed continues to raise rates to stem inflation that has risen above 8%, Japan had to intervene in September to support its currency for the first time since 1998, fueling speculation that the country might be forced to sell Treasuries to further yen support.

This situation is not limited to Japan. In recent months, countries around the world have been cutting foreign exchange reserves to protect their local currencies from a rising dollar.

According to the International Monetary Fund, central banks in developing countries have cut their holdings by $300 billion this year.

At best, this means limited demand from a group of price-insensitive investors who traditionally invest about 60% or more of reserves in dollar investments.

Peter Bukvar, chief investment officer at Bleakley Financial Group, said on Monday that it is dangerous to think that the US Treasury “will eventually find buyers to take the place of the Fed, foreigners and banks.”

At Citigroup Inc. are concerned that a reduction in foreign central bank holdings could trigger new shocks, including the possibility of so-called value-at-risk shocks, where sudden market losses force investors to liquidate positions quickly.

Investors should bet on lower swap spreads “to prepare for further CBR selling and cash rushing,” Jason Williams, strategist at Citigroup, wrote in a report.

Such a shock is more likely, according to the report, “given that the risks associated with the Fed’s hawkish stance remain.”

Banks out of the game

In the past decade, when one or two key buyers of Treasury bonds backed off, other buyers took over. Things are different this year, according to Jay Barry, strategist at JPMorgan Chase & Co.

Demand from US commercial banks has fallen as the Fed’s tightening policy drains the reserves of the financial system. In the second quarter, banks purchased the lowest number of Treasuries since the last quarter of 2020.

“The drop in demand from banks is striking,” he said. “As deposit growth has slowed sharply, this has reduced banks’ demand for Treasury bonds, especially as their asset life has increased dramatically this year.”

According to Barry, all of this creates a bearish betting environment.

The Bloomberg US Treasury Total Return Index has lost about 13% this year, almost four times more than it did in 2009, its worst performance in a year since its inception in 1973.

However, as structural support for Treasury bonds declines, other buyers are coming in, even though the stakes are higher. Households, a universal group that includes US hedge funds, posted the largest second-quarter gain in Treasuries of any investor tracked by the Fed.

Some believe that private investors have good reason to consider Treasury bonds as an attractive asset now, especially given the risk of Fed tightening, which is pushing the US into a recession, and high yields that have reached multi-year highs.

“The market continues to evolve and try to figure out who these new end customers will be,” said Gregory Faranello of AmeriVet Securities. “In the end, in my opinion, it will be domestic accounts, because interest rates are approaching the point where they will be very attractive.”

John Majiire, a portfolio manager at Vanguard Group Inc., believes that large excess savings held in US banks that are barely making a profit will force “people to move into the short-term segment of the Treasury bond market.”

“The estimates are more attractive as the Fed approaches the end of the current rate hike cycle,” he added. “The question is, are you ready to take the risk now or wait until the Fed peaks in its policy.”

However, most expect yield growth and increased market turbulence. Debt market volatility rose in September to its highest level since the global financial crisis, and market volume recently hit its worst since the start of the pandemic.

“The Fed and other central banks have been suppressing volatility for years, and now they are actually creating it themselves,” said Glen Capelo of Mischler.

Prepared by Profinance.ru by materials Bloomberg agency

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