A changing of the guard among the biggest buyers of US Treasuries has Wall Street veterans bracing for further pain in the world’s largest bond market.
Increasingly absent are steady-handed investors including foreign governments, US commercial banks and the Federal Reserve. In their place, hedge funds, mutual funds, insurers and pensions are piling in. Market watchers are quick to note that unlike their more price-agnostic predecessors, the new buyer base is likely to demand a heavy premium to finance Washington’s spendthrift ways, especially with debt sales set to surge as deficits swell.
The upshot, they warn, is that even with Treasuries mired in a third straight year of declines and 10-year yields climbing to the highest since 2007, more volatility and further losses — particularly for longer-dated bonds — are on the horizon. Given yields directly influence everything from mortgage rates to corporate borrowing costs, that’s bad news for a US economy already struggling to avoid tipping into a recession as soon as next year.
“We have an abnormal supply-demand situation in that the quantity of debt the government has to sell is a lot” and will “remain a lot,” Ray Dalio, the founder of Bridgewater Associates, said earlier this month in an interview with Bloomberg TV’s David Westin. Dalio, like fellow Wall Street titan Larry Fink, said he expects 10-year yields to exceed 5% in the near future. “The buyers are less inclined to buy the debt, for a variety of reasons” including that “many have gotten whacked. There’s lots of losses.”
Of course, some argue that the pullback of central banks, and in particular the Fed’s diminished role in the market, is more a return to normalcy than anything else after years of subdued liquidity and dampened volatility.
The ICE BofA MOVE Index, which tracks price swings on US bond options, has had an average reading 124 over the past year, almost double its measure over the previous decade and closer to its average over the prior 50 years.
More activity could help restore investor confidence in the Treasury market’s role as a leading indicator of economic turbulence following years of distorted signals.
Still, that’s cold comfort to bond bulls already grappling with the worst stretch of losses for Treasuries on record. Ten-year yields touched 4.89% last week, the highest in over 15 years, before ending Thursday around 4.7% amid a week full of dramatic swings.
One key buyer will be hedge funds. Firms such as Citadel and Millennium Management have been particularly active in the basis trade and various forms of leveraged carry trades this year. US government bond holdings in the Cayman Islands, where more hedge funds are domiciled than anywhere else in the world, are near the highest on record, Treasury Department data through the end of July show.
Fast-money funds aren’t the only ones increasing their stakes. JPMorgan estimated in its mid-year outlook that mutual funds will scoop up $275 billion of net Treasury issuance this year, a nearly 14-fold increase from 2022, while pensions and insurers will buy another $150 billion, the most since 2017.
But that demand will come at a cost.
“It’s going to be a bumpy road finding that equilibrium in rates as these are more price-sensitive buyers,” Jay Barry, co-head of US rates strategy at JPMorgan Chase & Co., said in an interview. “This will result in a higher term premium and steeper yield curve over time.”
On the flip side, foreign holdings as a share of America’s national debt have been on the decline for a while, falling to around 27% earlier this year, the lowest since 2002, according to Fed data. Japanese accounts, historically among the most active buyers of US government bonds, in particular face prohibitively steep hedging costs amid this year’s plunge in the yen.
More recently, US commercial banks have been unloading Treasuries amid steep declines in deposit balances. Holdings of Treasuries and non-mortgage agency debt, the cleanest read of their stash of government securities, has tumbled from a record high of $1.8 trillion in July 2022 to about $1.5 trillion as of last month, Fed data show.
And then there’s the US central bank which, via its quantitative tightening program, is allowing up to $60 billion of Treasuries to roll off its balance sheet each month. It’s hoard of government debt has shrunk to about $4.9 trillion, down from a peak of $5.8 trillion last year.
“Previously inelastic buyers — central banks, foreign investors and banks — are now retrenching,” said Jean Boivin, a former Bank of Canada official and the current head of the BlackRock Investment Institute. “The Fed’s quantitative tightening means other buyers become more important.”
A run of weak auctions this week was capped by a particularly lackluster sale of 30—year bonds, with the securities being sold at a yield well above the prevailing market rate on Thursday, a sign of soft demand.
The shifting demand dynamics come as the US deficit continues to surge, topping $1.52 trillion in the 11 months through August, with no end in sight.
Amid the profligate spending, the amount of marketable US debt outstanding has ballooned to more than $25 trillion, a roughly 50% increase since the start of 2020. In August the Treasury Department boosted the size of its quarterly bond sales for the first time in 2 1/2 years, and most Wall Street dealers predict further boosts to auction sizes over the next two quarters.
What’s more, the government’s debt servicing costs have risen dramatically, climbing to about $600 billion a year as a result of the Fed’s interest-rate hikes, now accounting for roughly 14% of tax revenue.
“It does appear that supply – particularly from the demand side – is becoming a lot more worrisome and creating headwinds for the Treasury market,” said Gennadiy Goldberg, head of US rates strategy at TD Securities Inc. “If the macro does not win out and we are stuck here for longer than we expect – at these rates – and there’s not a recession, then the supply headwinds will become more and more relevant and impactful.”
For many, the impact is already plain to see.
A Fed measure of the term premium has surged by more than a percentage point over the past three months, turning positive for the first time since 2021 and fueling a dramatic ascent in long-end rates.
The gap between two-year notes and 10-year bonds, a common measure of the yield curve, has also spiked higher over the span (though it’s still negative), showing investors are demanding more to lock up their money longer term.
“We have to deal with a different buyer base for Treasuries,” said Priya Misra, a portfolio manager at JP Morgan Asset Management. “The marginal buyer of Treasuries will be asset managers. And that will mean more volatility since these buyers will be more price and flow sensitive. Foreign central banks had to invest their reserves and banks had to invest their deposits. But asset manager demand is a function of inflows and performance of different asset classes.”
This article was provided by Bloomberg News.