US Treasury market moves into uncharted waters

Even as the US economy is recovering from the Covid-19 shock, the costs of mitigating the impact of the pandemic are still stacking up. With the US government deficit at a peace time high, the extra spending must be financed by new government bond issuance.

Not only is the supply breaking records, but there have been significant changes in the ownership of Treasuries in recent years. Among other things, the shifts in supply and demand can explain what happened in March when the Federal Reserve (Fed) had to purchase $1.5 trillion of bonds to stabilise the market.

As investors look ahead, there are two key questions on their minds:

1. Who will purchase the continuing heavy supply of Treasury issuance?
2. Will we see renewed volatility in the Treasury market?

How the owners of Treasuries have changed

Apart from a few years around the turn of the century, the US has been running a persistent budget deficit. For a long time, the deficit was financed by large surpluses in China and oil-exporting countries, a symbiosis reflected in the build-up of global foreign exchange (FX) reserves.

While the financial crisis had a heavy toll on the US, foreign official institutions, mainly emerging market (EM) central banks, continued to build their reserves and purchase US assets including Treasuries.

However, a fundamental shift occurred in 2015 when China started shedding its foreign assets because of a falling current account surplus and domestic capital outflow. By 2017, China’s holdings of long-term Treasuries had dropped from $1.3 trillion to just over $1 trillion.

In addition, the sharp fall in commodity prices in 2015 had a detrimental effect on the current account surpluses of a number of commodity exporting countries.

As a result, the global US dollar FX reserves peaked at $7.5 trillion in 2014, fell to just above $7 trillion in 2017 and have not surpassed that peak since.

While private foreign investors have continued to purchase Treasuries, this has not been enough to offset the anaemic demand of official institutions. Consequently, after hitting a record high of 43% in 2015, the share of the rest of world in the Treasury market has fallen to 29%, as of the second quarter of 2020.

So, who were the domestic buyers that filled the void left by foreigners?

The figure below shows the change in the ownership of Treasuries between 2014 and 2020. The greatest increase was in the category of households. Even though the name would imply that it includes purchases of Treasuries by individuals, it is actually a residual category, as it encompasses all the market participants not covered in other categories. The increase in household ownership, as it turns out, mainly reflects the activity of leveraged investors, such as hedge funds.

In recent years, a relative value strategy where leveraged investors purchase Treasury bonds and simultaneously sell Treasury futures to pocket a small difference in price has gained popularity.

As banks were constrained by the stricter post-financial crisis environment, hedge funds moved in aggressively to benefit. While the exact size of funds committed to this strategy is unknown, at the peak, investors’ exposure could have been in the hundreds of billions of dollars.

A sudden stop in the Treasury market

The consequences of greater leveraged investor ownership of Treasuries and lacklustre demand by foreigners became apparent at the peak of the Covid-19 crisis.

The rapid spread of the virus initially led to lower Treasury yields, as investors rotated from risky assets to safer ones. However, the yields suddenly started to move higher. Between 9 and 18 March, the 10-year US Treasury yield more than doubled, moving from 0.5% to 1.2%. Moreover, the most liquid market in the world almost seized up, making buying or selling Treasury bonds very difficult and sending shockwaves through the whole financial system.

It was only after the Fed promised to purchase unlimited amount of bonds and started offering dollar liquidity swaps to other central banks that the Treasury market stabilised.

Please see the full paper at the foot of the page for a detailed explanation of the events in March and April.

The main lesson from these events was that government bond yields are not just sensitive to traditional drivers, such as expectations on interest rates and inflation, but also to supply and demand.

Who will finance the record budget deficit?

While the US economy is gradually healing, the costs of handling the pandemic are still stacking up. As of end of August, the rolling 12 month US budget deficit was close to $3 trillion after the CARES Act added more than $2 trillion to the already large deficit.

It is possible that Congress will approve another multi-trillion dollar stimulus programme. Coupled with lower tax revenue, that would take the US budget deficit close to 20% of GDP. In order to finance the deficit, the US Treasury has sharply increased issuance. On a rolling 12-month basis, the net issuance stands at $4 trillion

Looking ahead, the Treasury expects the issuance to remain high with the timing dependent on the passing of the next stimulus programme. In addition, the issuance is shifting further out along the yield curve, as the Treasury aims to increase the weighted average maturity of outstanding debt.

The key question then is: who will finance the heavy issuance associated with very large budget deficit.

A sharp spike in US private sector savings

The 2008 financial crisis led to a spike in the US private sector savings rate, as both households and corporations increased precautionary savings and reduced investments. The increase in private savings then helped to finance greater public deficit.

The Covid-19 induced collapse in consumption and investment initially led to an even greater increase in private savings, best highlighted by the US household savings rate increasing to 34% in April.

However, a major difference compared to the previous crises is that the deficit is now much more directly supporting consumer spending. In April, most Americans received a $1200 cheque as part of the CARES Act. In addition, millions of unemployed people received an extra $600 weekly unemployment benefit until the end of July.

Consequently, US retail sales have now more than recovered the Covid-19 drop and the household savings rate has fallen to 14%, as of end of August. At the same time, the US unemployment rate remains high at 7.9%.

The longer it takes for the economy to return to normality, the greater the pressure on private savings. With the unemployed living off their savings and government hand outs, the savings rate could fall further and result in less demand for Treasuries by the private sector.

Foreign savings to the rescue?

Between 2008 and 2013, foreigners increased their holdings of US Treasuries by more than $3 trillion. This is unlikely to be repeated, at least on this scale.

First, global savings were lower even before the Covid-19 shock. China’s current account surplus, for example, is only 1.2% of GDP compared to 4.8% in 2009. With the oil price unlikely to rise significantly, at least in the near term, the large surplus in oil exporting countries is a thing of the past.

Second, global savings are likely to fall further because most countries need to deal with the fallout of the Covid-19 crisis. For example, the EU will need to issue €750 billion of bonds over the next few years to finance the European recovery fund.

Nonetheless, the US still has the “exorbitant privilege” of issuing the global reserve currency. And perhaps ironically, further dollar weakness could spur EM central banks to increase their Treasury holdings, as EM central bank often intervene by purchasing dollars to prevent their currencies from appreciating too much.

The likeliest source of reserve purchases are a number of current account surplus countries in Asia. These countries already have sizable FX reserves and are known for intervening in the market. The reserves of countries such as Taiwan and Singapore have increased noticeably since March, indicating that the central banks indeed have leaned against the appreciation of currencies

More broadly however, there is not much evidence of a significant bid for Treasuries by EM central banks. After a short reprieve in May, foreign official institution continued to sell long-term Treasuries in June and July, with the sales topping $40 billion in these two months.

The end game and the Fed

Looking ahead, if domestic and foreign savings are indeed insufficient to finance the large budget deficit, the Fed will likely have to step in again. Yield curve control (YCC), a policy where the Fed would target certain points on the yield curve with its asset purchases has been discussed more prominently in recent months.

Such a move could help to keep the yields stable, as well as ensure demand for new issuance. This strategy has already been implemented by the Bank of Japan (BoJ). In 2016, the BoJ fixed the 10-year government bond yield near zero percent. Surprisingly, the BoJ has not had to purchase many bonds to keep the yield at zero. The policy has worked just through the expectation of purchases.

After the $1.5 trillion intervention in March, it is not clear if the implementation of the YCC in US would be as smooth. In case of significant supply and demand mismatch, the Fed could be forced to increase its balance sheet rapidly to keep the yields stable.

Furthermore, Japan is a net lender for the rest of the world, while the US is a net borrower. Should the Fed’s balance sheet growth stoke fears of outright debt monetization, this could lead to selling of US assets by the foreigners and put pressure on the dollar.

In sum, the uncertainty of demand from foreign investors and others at a time of sizable issuance means it could be hard for the Fed to avoid increasing its balance sheet. So investors should get used to the idea of a shift in prevailing monetary and economic orthodoxy, especially as the US budget deficit is likely to remain large for some time. In this environment, the long end of the yield curve would be most vulnerable to bouts of volatility.

The choices made by the policy makers today will likely have profound consequences for years to come. A move towards outright debt monetisation or even Modern Monetary Theory being put into practice cannot be ruled out. At any rate, we are certainly entering uncharted territory.