Rates at the long end of the Treasury curve have been in sharp focus since the start of 2021. Yields on these risk free assets underpin the valuation of risky assets like stocks. The inflation debate rages on globally. Undoubtedly, inflation has been conspicuously absent in the last decade despite the low interest rate regimes and unconventional monetary policies that have dominated the US and Global landscape since 2009. However, what is different this time around is the global massive fiscal thrust that was significantly smaller in the last crisis. To put things simply, consider the 2 following points –
First, in the US context post the GFC shock, the first major legislation for economic stimulus to be passed by Congress was the American Recovery and Reinvestment Act which was estimated to cost approx. US$800bn. In contrast, so far the 2 major legislations to have passed Congress are the CARES Act estimated at ~US$2Tn and the American Rescue Plan Act of 2021 at ~US$1.9Tn. Add to these, the likely legislations that are in the works and might be passed to provide additional fiscal stimuli – The American Jobs Plan at ~US$2.0Tn and The American Families Plan at ~1.5Tn. Admittedly, the final shape of these plans would be radically different as it passes through the chambers of Congress. Nonetheless, the scale of fiscal firepower deployed in this crisis is enormous. The below chart shows the fiscal deficit in 2009 vs that in 2020. (and 2021 yet to appear on the chart…)
Second, in Europe’s context, the potential upcoming EUR750bn common debt facility is unprecedented – to state the obvious – and potentially a game changer. It has taken a pandemic of gigantic proportions for the EU to finally band together in a marked response of cross border solidarity and take major steps towards fiscal coordination, if not fiscal union. Without a doubt, it is still a long way away and the pathway is littered with challenges before the money starts rolling in. Yet, it is large, it is unprecedented and it is something to not lose sight of.
The fiscal bazookas in this crisis, compared to the past crises, have hence been colossal. Yet, this article is not about the global inflation debate. To get into that debate, I always need to wield the sword of long term structural trends in productivity gains on account of technological improvement. But the above description of fiscal deployment sets the stage for the main point of this article. And that is, apart from inflation expectations, what are the factors to take into account to form a view on the future movement of Treasury Bond rates.
To start with, let us understand the ownership of US Treasuries. Foreign holders are said to account for about one third of all outstanding marketable US Treasury securities. Japan and China are the largest holders at approx. US$1.3Tn and US$1.1Tn respectively. And hence, shifts in demand for Treasuries from these foreign holders creates significant ripples in both the primary and secondary market for Treasuries. Let’s look at some recent data to understand this better. The below chart shows the 10 Year Treasury Yield since the start of 2021. The 10 Year Yield rose almost 75 basis points in the 2 months of Feb and Mar from about 1.0% to 1.75%.
The Japan Ministry of Finance releases data on its International Transactions in Securities every week, based on reports from the major investors in Japan. The below chart shows the net transactions during the months of Feb and Mar 2021. (Negative denotes net disposal of securities). In just the 2 weeks of February 2021, Japanese investors were net sellers of approx. US$30bn of foreign long term debt securities, predominantly US Treasuries. Due to their significance in the demand equation for US Treasuries, this was quite a body blow and yields spiked significantly. Add to this, the weak Treasury auction for the 7 Year Treasury note on 25th of Feb 2021. Lastly, one of the other critical factors probably, was primary dealers offloading Treasuries as well in anticipation of the SLR exemption being scrapped on 31st March 2021.
You have to remember that a 30 year JGB yields approx.. 0.6% which makes the US bond yield extremely attractive even on a hedged basis. Hence, every time US Treasury yields go up, the hedged yield becomes incrementally attractive for the Japanese insurance companies and pension funds. In April 2021, Japanese investors were net buyers of foreign long term debt securities for JPY1,423bn or approx.. US$13Bn. The Japanese insurance companies and pension funds are hence a key player in the US Treasury market and their investment trends need to be constantly monitored.
The second major buyer of US Treasuries is local pension funds, especially defined benefit plan funds. It is no secret that US Treasuries form a core part of their investment portfolios. Their mandate is simply to match the plan’s assets and investments with the expected future liabilities and US Treasuries are the safest ways of doing so. As rates rise, long dated treasuries become incrementally attractive to these funds who are then inclined to rotate back from equities into US Treasuries, providing vital support to investor demand for long dated Treasuries. Usually, pension funds favour buying Treasury STRIPS. For the uninitiated, STRIPS are essentially Treasury Notes or Bonds stripped from their coupons and converted into multiple zero coupon instruments that have a fixed maturity date. These instruments are best suited for the liability matching requirements of pension funds. The US Treasury (or more specifically the Treasury Direct website link provided below) provides monthly reports listing the total amount of outstanding and this is another data point worth monitoring. Any large increase in STRIPS outstanding indicates higher pension fund demand.
Lastly, and most importantly, there is always the elephant in the room – The Fed – who might just come up with more tricks up their sleeve in the form of stirring jargon like Yield Curve Control or Operation Twist, in order to damp down yields on long dated treasuries.
I emphasize again that I do not intend to transform this article this into a debate on inflation vs disinflation or deflation. But if you are betting against the long end of the Treasury curve, you just need to be watchful of all the players on the table and the potential cards they might be holding.
Good luck to Dr. Burry and of course to all of us as well!
To learn more about US Treasuries, take our Fixed Income Analysis course and watch the video at the below link!