Declining Treasury issuance. The improving budget deficit means the Treasury will be issuing fewer securities. The Treasury Department has already begun to reduce issuance by curtailing the dollar amount of certain auctions. This is likely to continue as the non-partisan Congressional Budget Office (CBO) projects a further narrowing of the budget deficit in the next few years, which will likely imply less Treasury issuance.
A decline in the amount of high-quality bonds. The International Monetary Fund (IMF) anticipates that the global supply of top-rated bonds will decline by $9 trillion in 2016 from the pre-financial crisis peak. Following the financial crisis and European debt problem, the number of AAA-rated bond issuers has shrunk, and the trend is expected to continue. High-quality mortgage-backed securities (MBS) issuance is already substantially lower due to the rise in interest rates and reduction in both refinancing and new loan origination. This development reduces the amount of high-quality bonds over the near term. All else being equal, a lower supply of higher quality bonds suggests firmer prices.
Better valuations. The subsequent rise in bond yields has put bond valuations on much better footing, especially since the bond market has a much more balanced view of when the Fed may start to raise interest rates. Japanese investors returned in force to the U.S. bond market in September, purchasing over $600 billion in bonds, and life insurance companies along with private pension funds, who typically buy to balance long-term liabilities with long-term bonds, may continue or resume purchases given the better valuations.
To be sure, investment flows are a potential risk when the Fed ultimately exits the bond market. An example is evident among some emerging market countries that have recently turned toward protecting their domestic currencies and not buying Treasuries, creating a source of lower demand. In addition, Wall Street firms that trade and make markets in bonds have become less active participants due to increasing regulatory requirements and may be less likely to support bonds or certain types of bonds. However, we view these risks as potential headwinds and not a major driver of bond yields. We will continue to monitor investment flows but do not believe that the Fed’s eventual withdrawal from the bond market translates into steadily higher interest rates. Fed interest rate hikes, economic growth, and the rate of inflation will continue to be the primary drivers of bond yields. The onset of rate hikes in coming years coupled with still-low yields suggests that interest rates are still headed higher, but gradually. A repeat of the recent bond sell-off is unlikely given better valuations and more balanced Fed expectations.
Anthony Valeri has been with LPL Financial since June 1993. As Senior Vice President and Market Strategist, Valeri is a member of the Research department’s tactical asset allocation committee and is responsible for developing and articulating fixed income and general market strategy.
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