Record Treasury Demand Keeping Yields Low as Supply Shrinks

Monday, 09 Apr 2012 11:36 AM

 

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Investors are plowing into Treasurys at a record pace as the supply of the world’s safest securities dwindles, ensuring yields will stay low regardless of whether the Federal Reserve undertakes more stimulus to fight unemployment.

Buyers bid $3.19 for each dollar of the $538 billion in notes and bonds sold this year, the most since the government began releasing the data in 1992 and on pace to beat the high of $3.04 in 2011. The net amount of Treasurys available will decline by 30 percent once proceeds from maturing securities are reinvested, according to data from CRT Capital Group LLC.

Skepticism about the U.S. recovery, as well as signs Europe’s debt turmoil isn’t over, is enhancing demand for Treasurys. This may keep yields from surging even if Fed policy makers refrain from a third round of quantitative easing, and allow the Obama administration to finance a fourth deficit exceeding $1 trillion at near-record low costs.

“Investors are holding an overwhelming amount of cash in the system and chasing fewer securities, which has supported Treasurys,” said Dominic Konstam, global head of interest- rates research in New York at Deutsche Bank AG, one of 21 primary dealers that trade with the central bank, in an April 5 telephone interview.

The benchmark 10-year note yield fell 16 basis points, or 0.16 percentage point, to 2.06 percent last week in New York, according to Bloomberg Bond Trader prices. The 2 percent security due February 2022 rose 1 12/32, or $13.75, to 99 16/32.

Treasurys lost 1.3 percent in the first quarter, according to the Bank of America Merrill Lynch Index, compared to a 13 percent return in the Standard & Poor’s 500 Index.

Supply to Fall

Short-maturity debt the Treasury sold at the height of the 2008 financial crisis to stabilize markets is coming off the market, generating more cash needing to be put to work even as new issuance remains steady.

The net supply of Treasurys, or gross issuance minus the amount of maturing debt, will fall by an average of $32.5 billion a month this year, to $77.3 billion, which will leave an average of $99.4 billion of investable cash a month from maturing debt, up from $68.1 billion in 2011, according to Ian Lyngen, a strategist in Stamford, Connecticut, at CRT Capital Group and part of a team led by David Ader which has been ranked first by Institutional Investor magazine in government-debt strategy for the past six years. This comes as government sales stay relatively constant at about $176.75 billion a month, he said.

“This will provide an offsetting bullish underpinning to the Treasury market,” Lyngen said in an April 5 telephone interview. “The U.S. has moved past crisis mode and budgets are becoming more manageable, despite the ongoing debate in Washington.”

Maturity Lengthens

Average maturity of government debt has risen to 62.8 months from 49.4 months during the financial crisis in last quarter of 2008. The government has taken on $4 trillion more in debt since then.

Investors have continued to pour cash into bonds funds at the expense of equity funds as debt mutual funds have attracted $62 billion this year and $837.4 billion since 2008, compared with a $1.6 billion drop in equity funds this year and a $396.8 billion drop since 2008, according to data compiled by Bloomberg and the Washington-based Investment Company Institute.

Taxable bond funds attracted $5.8 billion in new money and hybrid funds $1.82 billion in the week ended March 21, the Washington-based Investment Company Institute said March 28. Domestic stock funds had redemptions of $1.79 billion.

Renewed Speculation

Employers in the U.S. added fewer jobs than forecast in March, underscoring Fed Chairman Ben S. Bernanke’s concern that recent gains may not be sustained without a pickup in growth.

The 120,000 increase in payrolls was the fewest in five months, Labor Department figures showed April 6. The increase was less than the most pessimistic forecast in a Bloomberg News survey in which the median estimate called for a 205,000 rise. Unemployment fell to 8.2 percent, the lowest since January 2009, from 8.3 percent.

“It keeps the Fed in play,” Jason Brady, who manages bonds at Thornburg Investment Management in Santa Fe, New Mexico, which oversees $72 billion, said in an April 6 telephone interview. “We had bought into a story, as a market, that was about continuous improvements in the employment situation. This definitely puts that into question.”

‘Liquidity Overhang’

Since the financial crisis the growth in the money supply in the U.S. has outstripped the rate of growth of the value of assets, leading to a “liquidity overhang,” according to Deutsche’s Konstam, causing investors to purchase bonds in order to put the cash to work.

In response to the crisis, the Fed tripled the size of its balance sheet to $2.88 trillion on March 28, from $905.7 billion in September 2008 as it created balances it used to bolster the financial system.

Rising inflation expectations may cause investors to slow their purchases of Treasurys and switch to higher-yielding assets. The difference between the yield on the 10-year Treasury note and its comparable maturity inflation-indexed security, the so-called break-even rate, rose to 2.25 percentage points from a yearly low of 1.95 at the start of January, indicating the market expects price increases to accelerate.

The Fed has purchased $1.4 trillion in mortgage and $900 billion of Treasury debt in two rounds of asset purchases beginning in November 2008.

‘Enjoying the Benefits’

“We are still enjoying the benefits of enormous asset purchases, and that is keeping a lid on rates, but inflation expectations are on the rise,” said Jeffrey Schoenfeld, a partner and chief investment officer in New York at Brown Brothers Harriman & Co., which manages $33 billion in assets in a telephone interview on April 3. “With expectations of growth improving, it’s hard to hold rates at historical low level.”

Demand for Treasurys is also being fed by banks needing to add safe assets to meet new reserve rules under the Dodd-Frank financial-overhaul law and Basel III regulations set by the Bank for International Settlements in Basel, Switzerland. Lenders have increased holdings of government debt since 2008 to protect their capital after the credit crisis caused more than $2 trillion in writedowns and losses at global financial institutions, according to data compiled by Bloomberg.

U.S. commercial lenders bought $62.8 billion of Treasurys and securities of agencies this year, compared with $62.6 billion in all of 2011, Fed data show.

Corporations flush with cash are also contributing to demand for Treasurys. Since 2009, the amount of cash held by non-financial companies has increased 56 percent to a record $2.232 trillion, Fed data show.

More Demand

“Banks have to purchase more Treasurys, corporations have record cash on hand that they are not putting to work, so they put them in Treasurys,” Tom Higgins, global macro strategist in Boston at Standish Mellon Asset Management Co., which oversees about $85 billion in bonds, said April 3 in a telephone interview. “After being kicked in the stomach twice over the past decade in risk markets, you see more generalized demand for fixed income.”

Bernanke said March 26 that further stimulus may be needed to lower unemployment amid risks that signs of strength in the economy, which caused a 5.56 percent loss for bonds maturing in 10 years or more last quarter, may fade in the second half of 2012.

The central bank on March 13 reiterated its previous statement that economic conditions would probably warrant “exceptionally low” interest rates at least through late 2014. It has kept its target rate for overnight bank loans to a range of zero to 0.25 percent since December 2008.

Risks Remain

“I don’t think the market is totally convinced, nor is the Fed for that matter, that we’re out of the woods,” said James Sarni, senior managing partner in Los Angeles at Payden & Rygel, which manages $60 billion in a telephone interview on April 3. “As long as that’s the case, there’s going to be a demand for Treasurys.”

Investors also see risk in Europe. The yield on Spain’s 10- year bonds has jumped about 90 basis points, or 0.90 percentage point, since Prime Minister Mariano Rajoy said on March 2 that his government wouldn’t meet its budget deficit target, raising the possibility of a second bailout. The additional yield investors demand to hold Spanish 10-year bonds instead of similar-maturity German bunds climbed to more than 400 basis points last week, the most since Nov. 30.

This flight to quality comes as there are fewer alternatives to Treasurys for investors seeking the greatest safety. A Bank of America Merrill Lynch index shows the number of issues in its AAA index has fallen to 3,611 from 5,331 in 2007.

Concerns Linger

“The economic news may be a bit better but it’s hard to look at anybody and hear a reaction that things are getting a lot better,” said Brian Edmonds, head of interest rates at Cantor Fitzgerald LP in New York, a primary dealer, in a telephone interview on April 3. “In an environment like this, people still have plenty of cause for concern. Not only are they looking at what could potentially happen in Europe, but what could potentially happen here in the U.S.”

After buying $2.3 trillion of assets to support the economy in two rounds of quantitative easing from December 2008 to June, the central bank has been replacing shorter maturities in its holdings with longer-term debt to cap borrowing costs without increasing holdings on its balance sheet. The $400 billion program, known as Operation Twist, is due to end in June.

‘All the Cards’

“These people hold all the cards,” said Charles Comiskey, head of Treasury trading at Bank of Nova Scotia in New York, a primary dealer, in a telephone interview on April 3. “Three or 4 percent GDP growth is not enough for them to change policy. It gave people the clear sign to go back in there and buy Treasurys.”

After rising to as high as 2.4 percent last month from 1.88 percent at the end of 2011, the yield on the benchmark 10-year note will finish 2012 at 2.49 percent, according to the average estimate in a Bloomberg News survey of primary dealers. That’s the same as a January poll, suggesting the market isn’t ready to declare a bear market in bonds after a 30-year bull run.

While the amount of marketable debt outstanding has more than doubled to $10.2 trillion from $4.34 trillion in mid-2007 as the U.S. sold bonds to pay for spending programs designed to pull the economy out of the worst financial crisis since the Great Depression, interest expense equaled 3 percent of the economy in fiscal 2011 ended Sept. 30. That’s down from 4 percent in 1999, when the U.S. ran budget surpluses.

“In the back of the market’s mind, if rates creep up too high, the Fed will just push back,” said Mark MacQueen, partner and money manager in Austin, Texas, at Sage Advisory Services Ltd., which oversees $10 billion in a telephone interview on April 2. “The market is not big as it appears.”

© Copyright 2014 Bloomberg News. All rights reserved.

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