“As the Fed recedes a little bit into the background, all of these other questions need to start coming back into the foreground,” Vogel said.
The potential for a glut in Treasuries is emerging as some measures show buyers aren’t giving themselves any margin of safety. A valuation tool called the term premium stands at minus 0.56 percentage point for 10-year notes. As the name implies, the term premium should normally be positive and has been for almost all of the past 50 years. But in 2016, it’s turned into a discount.
Some of the highest-profile players are already sounding the alarm. Jeffrey Gundlach, who oversees more than $100 billion at DoubleLine Capital, warned of a “ mass psychosis” among investors piling into debt securities with ultra-low yields. Bill Gross of Janus Capital Group Inc. compared the sky-high prices in the global bond market to a “supernova that will explode one day.”
Despite the increase in supply, things like the gloomy outlook for global growth, an aging U.S. society and more than $9 trillion of negative-yielding bonds will conspire to keep Treasuries in demand, says Jeffrey Rosenberg, BlackRock Inc.’s chief investment strategist for fixed income.
What’s more, the Treasury is likely to fund much of the deficit in the immediate future by boosting sales of T-bills, which mature in a year or less, rather than longer-term debt like notes or bonds.
“We don’t have any other choice -- if we’re going to increase the budget deficits, they have to be funded” with more debt, Rosenberg said. But, “in today’s environment, you’re seeing the potential for higher supply in an environment that is profoundly lacking supply of risk-free assets.”
Deutsche Bank AG also says the long-term fiscal outlook hinges more on who controls Congress. And if the Republicans, who hold both the House and Senate, retain control in November, it’s more likely future deficits will come in lower than forecast, based on the firm’s historical analysis.
However things turn out this election year, what the Fed does with its $2.46 trillion of Treasuries may ultimately prove to be most important of all for investors. Since the Fed ended quantitative easing in 2014, the central bank has maintained its holdings by reinvesting the money from maturing debt into Treasuries. The Fed will plow back about $216 billion this year and reinvest $197 billion in the next, based on current policy.
While the Fed has said it will look to reduce its holdings eventually by scaling back reinvestments when bonds come due, it hasn’t announced any timetable for doing so.
“It’s the elephant in the room,” said Dov Zigler, a financial markets economist at Bank of Nova Scotia. “What will the Fed’s role be and how large will its participation be in the Treasury market next year and the year after?”