Lately, the markets have been obsessed with the possible end of the Fed’s asset purchase programs. This has led investors to try to predict the point at which yields might rise. In this article I will provide some points to substantiate the idea that the US treasury market may stay bullish for a while.
Start of the end
When the Fed bond purchasing program stops, it will not mark some kind of isolated turning point event. Who will start buying bonds when the Fed stops depends on many factors, such as the yield and often overlooked the actual supply of bonds. The supply of US treasury is half of what it was 1.5 years ago. Right now, the Fed’s assets purchases under QE3 are on their way to being completed and it has been 15 months since markets adjusted for the ‘start of the end’
As such, when the Fed stops to sweep up whatever available debt there is, investors start to expect higher official interest rates. However, in the same way that the surge in US forward rates front-ran the actual start of the ‘tapering’ in 2013 – with the first reduction in purchases not actually seen until January 2014 – money market spreads are actually normalizing. Additionally, the FOMC (Federal Open Market Committee) has clearly signaled the future path of US rates through forward guidance. Furthermore, consensus expectations are gravitating towards a lower terminal rate.
Last month, returns from fixed income were positive everywhere, apart from some areas of high yield and EM (exhibition 1). Year-to-date, returns for global fixed income have reached 5-6%, with the Eurozone periphery at 10%.
US economic recovery
The general consensus is that the US economy is currently in a state of recovery. Because of this, many investors are afraid of policy normalization. However, although the 4% US GDP in Q2 looked decent, one must be aware that this was measured over the horrible Q1 which saw a decline of 2%. Measured over the same period in 2013, the US economy grew by 2.4% and is expected to grow this year by 1.7%, which is the lowest GDP growth outside of a recession year since measurements started in 1930.
US 2 and 10 year treasury
The yield difference between the US 2 and 10 year treasury acts as an economic indicator, and gives an idea about the health and sustainability of recovery. Usually the yield curve steepens in recovery, thereby widening the yield gap. This was seen in the recoveries of the early 90’s and 2000’s. However, this year the curve has flattened by about 65 points. See exhibition 2.
Exhibition 2: Green: 2-year nominal, Blue: 10-year nominal, Grey: Difference
New financial regulation
New regulations such as Basel III and Dodd Frank require banks to increase their holdings in risk-free assets. This prompts banks to continue purchasing treasuries. Additionally, new regulations in the money market may prompt institutions to move their cash into short term treasuries. Creating as much as $500 billion of demand in two years, according to Bank of America.
Freddie and Fannie
Due to the housing market recovery in the US, GSE’s (Government sponsored entities) Fannie Mae and Freddie Mac have transformed from bail-out kids to cash cows. They have delivered more than $75 billion over the past 18 months. With their last payment due in September, they will have returned $218.7 billion to the Treasury in return for the $187.5 billion in aid they received after being placed under the government's wing. As money continues coming in, the US deficit has fallen to $460 billion in 2014 after being over a trillion dollars for the past few years. See exhibition 3. The more cash the treasury takes in, the lower the amount of new issued securities is. This results in lower yields.
The end of the Fed’s asset purchases has been an important focal point. However, there has been less appreciation of the reduction in the stock of Treasuries and Agencies available to trade. This combined with the decline in the flow of new bonds and a reduction in velocity as banks do less repo is a major factor for the yield. It is this repo that also impacts the cost at which bond positions can be funded, and it thereby affects the yield as well.
Widening US and Eurozone gap
How can we have both lower treasury yields and a strengthening dollar? This is a reasonable question, given widening rate differentials between the US and Eurozone (exhibition 4). If the US economy is recovering relative to the Eurozone and Japan, then interest rate differentials and the currency should move in the same direction. However, this ignores the fact that the separation between the economy and the bond market is nothing new (exhibibition 5). Bonds have not been responding to cyclical patterns in the way that many seem to expect.
Furthermore, with regard to currencies and bonds, the divergence in (exhibition 5) might correct in a number of ways. To start with, the dollar could strengthen against the euro (EUR/USD falls). Furthermore, there could be a shift in the expected yield differential. The chart shows that the 5y5y EUR-USD yield spread is at an extremely wide level, with Eurozone swap yields at record lows. This could correct in multiple ways. The US dollar yields could fall, euro yields could rise, or a combination of the two could occur.
The inevitable end of the Fed’s asset purchase program is often directly linked to upcoming rising yields. However, with the sluggish economic recovery, new financial regulation, and dramatic drop in the supply of new debt paper, this era of low yields will possibly continue even after tapering ends.
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Gelein has been interested in the financial world and global economics since high school. For over 3 years he has been a member of a university investment team, of which one year he was the treasurer.