As Fed Exits Bonds, Others Likely to Crowd Back In

Thursday, 05 May 2011 03:06 PM

 

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Reports that the U.S. bond market will meet its demise next month may be greatly exaggerated.

True, the Federal Reserve wraps up its $600 billion bond-purchasing program, known as QE2, at the end of June and in the process it will remove itself as the market's biggest buyer of US Treasury debt.

Many also fear a brewing political storm over the U.S. debt limit could do the market irreparable damage and note that Pimco, the world's largest bond fund, has already ditched its Treasurys.

Using recent history as a guide, however, some analysts note that buyers actually returned in droves to the Treasury market after the Fed's previous round of quantitative easing in 2009-2010 came to an end and expect this pattern to be repeated after QE2.

"Buyers came back after the end of the first program, and we think they will again," said Ira Jersey, interest rate strategist at Credit Suisse in New York.

Indeed, foreigners, who hold almost half of U.S. sovereign debt, came back in force at the end of the Fed's last quantitative easing program .

"Foreigners stepped back in very heavily," said Aneta Markowska, senior economist at Societe Generale in New York. "The Fed crowded them out, but that then generated a lot of pent up demand."

Federal Reserve data show foreigners and households, also large buyers, made record quarterly Treasury purchases between the Fed's two bond buying programs. Since the start of QE2 they have reduced Treasury purchases and increased investments in cash.

Households also increased investments in other debt types, including agencies, municipal and corporate bonds.

"It seems like other fixed income assets were the biggest beneficiary as they are closest in nature to Treasurys," said Markowska.

This suggests they are likely to continue to find fixed income attractive, which could be a boon for Treasurys.

The level of bond yields suggests little worry over the impending Fed departure, and many argue the Fed's exit is priced in.

"Post QE2 I think you will see a bit more volatility, I think liquidity will be lessened," said Rick Rieder, head of fundamental fixed income at BlackRock, who oversees $595 billion of the firm's $1.15 trillion in fixed income assets.

A larger driver of rates, he argues, will be the pace of economic growth and inflation — both of which appear subdued.

"We think we are going to be in a period for the next couple of years of decent but not tremendous economic growth," Rieder said. "We think that rates are going to move up, yields are going to trend higher, but we don't think they are going to move up dramatically."

A month-long rally in U.S. Treasury prices recently does increase the risk a slight backup could occur in June to attract other buyers if rates stay low, said Credit Suisse's Jersey.

"They may need higher yields to entice those buyers," he said.

He sees a significant jump, as predicted by bond bears Bill Gross and Jim Rogers, however, as unlikely.

The Fed has bought approximately $100 billion in Treasurys each month since QE2 was introduced, representing around two thirds of net sales of U.S. government bonds.

Benchmark 10-year note yields have dropped over a quarter of a percentage point since mid-April, to 3.19 percent. They are up from 2.50 percent before QE2 began in November, but lower than levels of around 3.80 percent when the first Treasurys buying program was launched in March 2010.

Bonds have also held up well in the face of a potential U.S. budget crisis and news that Standard & Poor's reduced to negative the outlook on United States' prized AAA rating.

If yields do rise through year end, it may only make more buyers return to the market.

"As they move along with the backup in Treasurys I think it will mean that people will continue to go into all fixed income assets," said BlackRock's Rieder.

© 2014 Thomson/Reuters. All rights reserved.

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