2023-10-13 17:59:15
A shift in the top buyers of U.S. Treasuries has Wall Street veterans bracing for further pain in the world’s largest bond market.
Steady bond investors, including foreign governments, U.S. commercial banks and the Federal Reserve, have gradually disappeared, replaced by an influx of hedge funds, mutual funds and retirement funds. Market watchers were quick to sense that this new group of buyers was likely to bear hefty bond premiums to finance the federal government’s profligate ways, especially as bond issuance surged as deficits ballooned.
The result, observers warn, is despite U.S. Treasury bond prices falling for a third consecutive year.10-Year Treasury Bond YieldClimbing to levels not seen since 2007, more volatility and further losses – especially in longer-dated bonds – are coming. With yields directly affecting everything from mortgage rates to corporate borrowing costs, that’s bad news for the U.S. economy trying to avoid a recession as soon as next year.
The supply is so large that buyers’ willingness is abnormally low
Ray Dalio, founder of Bridgewater Associates, said earlier this month that the bond supply situation is abnormal and that the amount of bonds the government must sell is very large and will remain large in the future. Larry Fink, CEO of BlackRock, the world’s largest asset management company, also said,10-Year Treasury Bond YieldIt will rise above 5% in the near future, and buyers are reluctant to purchase these debts for various reasons.
However, some people believe that the Federal Reserve’s (Fed) end of the bond market is more of a return to normalcy after years of sluggish liquidity and reduced volatility. More activity could help restore investor confidence in the U.S. Treasury market as a leading indicator of economic turmoil after years of distorted signals.
That’s little comfort to bond market bulls, however, who are already grappling with the biggest drop on record in U.S. Treasuries. The 10-year Treasury yield hit 4.89% last week, the highest level in more than 15 years, and closed around 4.7% on Thursday, marking a week of wild swings in yields.
Hedge funds become price of new buyers
As for hedge funds, another important buyer of U.S. debt, firms such as Citadel and Millennium Management have been particularly active this year in basis trading and various forms of leveraged carry trades. In its mid-year outlook, JPMorgan estimated that mutual funds would soak up $275 billion in net issuance of U.S. Treasuries this year, a nearly 14-fold increase from last year, while pensions and insurance companies would buy another $150 billion, the most since 2017. level.
But this need comes at a cost. Jay Barry, co-head of U.S. interest rate strategy at J.P. Morgan, said: “Because these buyers are more price sensitive, it will be a bumpy road to find the balance of interest rates. Over time, this will lead to higher term premiums. and a steeper yield curve.”
On the other hand, foreign holdings of U.S. Treasury debt have been declining for some time, falling to around 27% earlier this year, the lowest level since 2002, according to Fed data.Japan, historically one of the most active buyers of U.S. government bonds, hasJPYAt the time of sharp depreciation, it is especially faced with excessive hedging costs.
The U.S. deficit continues to soar with no end in sight
U.S. commercial banks have been selling off U.S. Treasuries recently as deposit balances have fallen sharply. As of last month, U.S. Treasury and non-mortgage agency bond holdings had fallen to about $1.5 trillion from a record high of $1.8 trillion in July 2022, Fed data showed.
As demand dynamics change, the U.S. deficit continues to soar, exceeding $1.52 trillion in the 11 months to August, with no end in sight. Amid the federal government’s profligate spending, the outstanding U.S. debt balance has surged to more than $25 trillion, up about 50% since the beginning of 2020.
Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, said supply is indeed becoming more of a concern and creating headwinds for the U.S. Treasury market. If the macroeconomics don’t win out, interest rates will remain at current levels for longer than expected, and, absent a recession, supply-side headwinds will become increasingly important and influential.
Surge in bond premiums pushes long-term yields higher
But for many, the impact is already apparent. The Fed’s measure of bond term premiums has surged more than a percentage point in the past three months, turning positive for the first time since 2021 and driving a sharp rise in long-term yields.
The spread between the 2-year Treasury note and the 10-year Treasury note, a common measure of the Treasury yield curve, has also climbed sharply over that time frame (although the spread remains negative), suggesting investors need to pay more attention to more funds to lock up their funds for the long term.
“We have to deal with different buyers of government debt, and the marginal buyers of government debt will be asset managers,” said Priya Misra, a portfolio manager at J.P. Morgan Asset Management. “That means more volatility because these buyers have a strong interest in price and Flows are more sensitive. Foreign central banks have to invest their reserves, banks have to invest their deposits. But demand from asset managers is a function of inflows and the performance of different asset classes.”
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