Crunch time for Treasuries as end of QE looms

Official institutions with deep, almost limitless, pockets are the biggest holders of US government bonds, and as one of the biggest tests this immense market has ever faced approaches, their reaction will be crucial.

Years of bond purchases by the US Federal Reserve via quantitative easing and the hefty accumulation of Treasury securities by other central banks and currency reserve managers means these buyers now account for nearly 60 per cent of the outstanding $10.544tn market.

Such a presence illustrates how a significant portion of the world's largest sovereign debt market currently resides with investors that are somewhat insensitive towards changes in underlying prices that move inversely with yields, thereby acting as a cap on long term US interest rates.

Indeed to the surprise of many bond managers, long-dated bonds have already delivered a total return in excess of 14 per cent this year, with the 30-year Treasury yield touching a 13-month low of 3.24 per cent on Monday.

"Once you include the Fed, other central banks and reserve managers, you have a significant part of the Treasury market held by entities that are less likely to sell than other investors," says David Ader, strategist at CRT Capital.

Demand from foreign buyers, with China for example having shifted more of its Treasury portfolio into longer dated maturities this year, is playing an important role in maintaining low long term yields.

Richard Madigan, chief investment officer at JPMorgan Private Bank says there are a lot of what he calls "non-economic investors involved in fixed income markets that are deep pocketed long term buyers focused on owning a safe asset or looking to match liabilities with assets".

This is compounded by the dynamic that many sovereign wealth and pension funds look at bonds in a global context. In that respect, the yield on US Treasuries is much higher than many other government securities.

"We have an investor base looking at a pool of assets and Treasuries are the cheapest on a relative basis," says Mr Madigan.

RBS Securities estimates that the Fed owns $2.4tn of the $10.544tn in outstanding Treasury paper - excluding short term Treasury bills - amounting to nearly a quarter of the overall market.

However this weighting rises sharply for longer dated paper, and that move has also been emulated by foreign investors in recent years, helping cap the rise in long term US interest rates.

As of May, Treasury data shows foreign official entities held $4.09tn of US Treasuries, with $3.73tn in notes and bonds. Among foreign investors, China leads the way with $1.27tn, followed by Japan at $1.22tn and longer-dated maturities have grown in popularity.

Barclays estimates that foreign holdings of coupon Treasuries purchased at auctions have risen by $268bn over the six months to May and are up $343bn over the year to May. The bank says since 2007 foreign investors have tripled their buying in 10-year notes to 33 per cent from 11 per cent and now allocate a 7 per cent share to 30-year bonds, up from 3 per cent.

How long this foreign demand continues is a looming question. Sentiment may be tested once the Fed ends QE as planned in October and net issuance of Treasury debt starts rising after a contraction earlier this year. The sharp rise in long dated Treasury yields last summer was driven in part by foreign central banks selling some of their holdings.

"We may be close to an inflection point for the Treasury market in terms of supply and demand," says Bill O'Donnell, strategist at RBS Securities.

Zach Pandl, portfolio manager at Columbia Management says the Fed has absorbed a huge amount of issuance, representing two-thirds of coupon issuance beyond a maturity of 10 years during the first quarter, but now that picture is shifting.

The maturing of Treasury securities sold in 2008 and 2009 when the slumping economy generated massive budget deficits means the US will soon need to issue more paper to refinance its portfolio.

With the Treasury looking to extend the maturity of its outstanding debt, and the US budget deficit projected to grow from 2016, investors in the absence of the Fed will be asked to buy a greater amount of longer-dated paper.

Wrightson Icap estimates the net supply of Treasuries maturing in more than ten years will rise by more than $250bn an increase of 30 per cent over the next 18 months if no changes are made to the Treasury's auction calendar.

"The net issuance of long term Treasury debt is rising as the Fed steps away from its bond purchases and those long maturity bonds need to find a home, presumably at lower prices [and higher yields]," says Mr Pandl.

As the Fed ends QE in October and net issuance of Treasury debt rises, the prospect of higher yields and lower prices ultimately rests on the performance of the economy.

"Unless we are really surprised by something on the inflation front, yields will remain low," says Mr Madigan. He says the economy and inflation are only gradually growing and that the Fed won't talk about raising rates until the middle of 2015.

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