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Summary

  • Since the US economy is back on the growth path and unemployment is lowering towards 6.5%, there has been heightened focus on the QE taper and its impact.
  • However, the maturing of outstanding Treasury holdings in 2016 as the Fed shrinks its balance sheet may pose a bigger threat than the taper of the bond buying program.
  • Treasury ETFs will be adversely affected and long dated bond funds (TLT) will be impacted more than short dated bond funds (SHY).

More than 5 years after the collapse of Lehman Brothers in Sept. 2008 plunged the United States into recession, the American economy seems to finally back on the path to recovery. Quarter on quarter GDP growth was 2.4% in Q4 2013 (the eleventh consecutive quarterly growth) and unemployment rate has come down from crisis levels of nearly 10% to 6.7% in the Feb. 2014 payroll report. But perhaps the most symbolic sign of recovery is the tapering of the quantitative easing (QE) program from $85 billion of monthly debt purchases in 2013 to $65 billion in Mar 2014. The Federal Reserve has been using QE as an extraordinary measure to lower borrowing rates after all conventional means has been exhausted. With QE firmly on track to be ended within 2014, have the American economy finally see the light at the end of the tunnel?

Prelude: QE and the expanding US Treasury market

Since the Federal Reserve started purchasing $300 billion of Treasury securities in March 2009, the US Treasury market has doubled from $5.77 trillion in 2009 to $11.85 trillion in 2013. This is largely driven by the buying of notes and bonds (debt instruments more than 1 year in terms of maturity).

(click to enlarge)

Chart 1 The US Treasury market has doubled from 2008 to 2013 (Source: SIFMA)

Bills

Notes

Bonds

TIPS

Total

2007

999.5

2,487.4

558.4

471.4

4,516.7

2008

1,861.2

2,791.5

591.9

529.6

5,774.2

2009

1,793.5

4,181.1

717.9

568.1

7,260.6

2010

1,772.5

5,571.7

892.6

616.1

8,853.0

2011

1,520.5

6,605.1

1,064.1

738.8

9,928.4

2012

1,629.0

7,327.1

1,240.2

849.8

11,046.1

2013

1,592.0

7,881.7

1,408.2

972.6

11,854.4

Table 1 This is largely driven by the purchase of notes and bonds (Source: SIFMA)

Within the market, foreign nations (mainly China and Japan) and the Federal Reserve are the biggest holders of outstanding U.S government debt.

2006

2007

2008

2009

2010

2011

2012

2013Q3

Individuals

355.10

183.00

193.60

868.50

1,220.90

828.20

1,108.90

911.40

Mutual Funds

263.90

382.10

785.40

700.00

682.20

871.90

971.80

1,146.90

Banks

47.80

39.40

260.10

268.00

352.80

402.90

518.40

392.30

Insurance

197.90

141.90

171.30

222.00

248.30

263.50

262.00

265.00

Fed Reserve

778.90

740.60

475.90

776.60

1,021.50

1,663.40

1,666.10

2,072.30

State/Local Gov.

551.70

588.10

602.40

585.10

591.90

545.40

533.60

498.00

Foreign

2,126.20

2,376.40

3,253.00

3,670.60

4,458.80

5,006.90

5,273.80

5,672.90

Pension Funds

363.40

418.40

389.70

454.10

505.40

564.40

665.60

726.60

Other

177.10

198.90

171.30

179.60

218.80

221.20

192.00

202.20

Total

4,862.00

5,068.80

6,302.70

7,724.50

9,300.60

10,367.80

11,192.20

11,887.60

Table 2 Foreign countries and the Fed holds the most US Treasuries (Source: SIFMA)

However, within the foreign debt holders category, the two largest creditors Japan and China hold no more than $1.3 trillion each. In other words, the Federal Reserve is the single largest holder of Treasuries at $2 trillion and the biggest driving force behind the market and yield pricing.

Aug2013

Sep2013

Oct2013

Nov2013

Dec2013

Jan2014

China, Mainland

1,268.10

1,293.80

1,304.50

1,316.70

1,270.00

1,273.50

Japan

1,149.10

1,178.10

1,174.40

1,186.40

1,182.50

1,201.40

Belgium

166.80

172.50

180.30

200.60

256.80

310.30

Carib Bkg Ctrs 4/

301.90

300.90

292.00

290.90

294.30

293.30

Oil Exporters 3/

246.50

245.70

236.80

236.20

238.30

246.40

Brazil

252.90

249.20

246.70

246.90

245.40

246.00

Taiwan

183.60

185.90

184.50

183.70

182.20

179.10

Switzerland

181.20

177.20

174.30

176.60

176.70

173.70

Table 3 China and Japan hold no more than $1.3 trillion each as of Jan 2014 (Source: US Treasury)

As of third quarter of 2013, the Fed holds 17.4% of outstanding issuance (per Table 2 Q3 figures) while China and Japan holds 10.8% and 9.9% each (per table 3 Sep 13 figures).

As the biggest buyer of Treasuries, the Fed can exercise its considerable purchasing authority to influence medium and long term yields. Judging by the bond market statistics, the QE program has been quite effective in forcing down yields.

The yield curve sways to the Fed's tune

The QE program has been successful in forcing down the yield curve from 2009 to 2012 via buying of Treasury notes and bonds. 3 year yields dropped from 1.7% to 0.36% while 30 yields dropped from 4.63% to 2.89%.

Chart 2 The yield curve dropped from 2009 to 2011 (Source: www.quandl.com/usa/usa-interest-rates and Federal Reserve Economic Data)

Chart 3 Yield curve started picking up after 2012 (Source: www.quandl.com/usa/usa-interest-rates and Federal Reserve Economic Data)

31-Dec-09

31-Dec-10

30-Dec-11

31-Dec-12

31-Dec-13

20-Mar-14

2 year

1.14

0.61

0.25

0.25

0.38

0.45

3 year

1.7

1.02

0.36

0.36

0.78

0.9

7 year

3.39

2.71

1.35

1.18

2.45

2.31

20 year

4.58

4.13

2.57

2.54

3.72

3.4

30 year

4.63

4.34

2.89

2.95

3.96

3.67

Table 4 Yields dropped through 2009 to 2011 only to pick up slightly from 2012 to 2014 (Source: www.quandl.com/usa/usa-interest-rates and Federal Reserve Economic Data)

But since 2012 the yield curve has been rising again particularly in the long end of the curve. 7 year yields rose from 1.18% to 2.31% and 30 year yields increase from 2.95% to 3.67% as the portion of long dated securities (6-30 year range) in the bond buying program dropped from $75 billion per month in 2011 to $45 billion per month in 2014. Overall bond buying still increased as more reduction in long dated treasuries purchases was offset by an increase in mortgage securities purchases.

This swaying of the yield curve to the tune of the QE program serves to illustrate the sensitivity of the Treasuries pricing to the systematic market operations of the Fed. If bond purchasing was reduced and eventually eliminated, yields will definitely be back on the upward march. More importantly, the maturing of the outstanding bonds on the Fed's balance sheet will lead to a $2 trillion refinancing wave in the $11 trillion debt market as these proceeds will not be reinvested any more. The next question to ask is what is the impact of this refinancing wave?

After the music is over: tapering and the refinancing wave

Out of the $2 trillion holdings on securities, about $1.6 trillion will mature over the period of six years from 2016 to 2022 at a rate of $227 billion a year (or about $19 billion a month)

(click to enlarge)

Chart 4 A refinancing wave hits the Treasury market from 2016 to 2022 as proceeds of maturities are no longer reinvested (Source: SOMA)

Year

Maturing bonds ($Billions)

Year

Maturing bonds

2014

0.18

2027

22.63

2015

3.52

2028

7.53

2016

212.07

2029

10.79

2017

190.11

2030

8.66

2018

359.46

2031

3.08

2019

300.63

2036

11.51

2020

207.08

2037

26.58

2021

157.40

2038

33.59

2022

168.37

2039

95.90

2023

64.88

2040

95.39

2024

5.23

2041

102.54

2025

12.52

2042

71.97

2026

15.16

2043

10.64

Grand Total

2,197.42

Table 5 Outstanding holdings of 1.6 trillion matures from 2016 to 2022 (Source: SOMA)

In fact this debt maturing may be even more significant that the 2014 tapering itself as only $0.18 billion worth of bonds mature in 2014 followed by $3.52 billion in 2015 in the absence of bond buying.

Unless Japan and China plans to provide $1.6 trillion in liquidity to make up for the Fed reduction of holdings, the Treasury market is staring at a refinancing gap and long term yields spiking over the course of six years. Either that or the US government will have to reduce its debt by $1.6 trillion through fiscal austerity to avoid this credit tightening scenario.

2016 and beyond; the twin threats of debt refinancing and rising rates

As the Fed looks to reduce its balance sheet from 2014 onwards via tapering and then maturing of outstanding holdings from 2016, there is also speculation on the normalization of monetary policy by raising the fed funds rates from the current 0-0.25% level after the tapering ends. Since the latest Federal Open Market Committee meeting in 19 March 2014, the probability that the Fed funds rate will increase in June 2015 increased to 56% from 42% while the median estimate for the Dec 2015 fed funds rate increased from 0.75% to 1%.

In other words, even the short end of the curve is starting to look risky for Treasury bill holders and together with a rising of long term yields, it is becoming a two prong pincer on the Treasury market. How will the market react to this tightening of credit conditions from 2015 onwards?

Long term bonds vs. medium term notes; which is the weapon of choice?

Bond prices move inverse to the direction of yields as future cash flows are discounted at higher rates to arrive at a lower present value or price. The longer the tenor of the fixed income securities, the more sensitive the prices are to changes in interest rates as long dated fixed income securities have longer duration. Duration is in bond mathematics a measure of price sensitivity to interest rate fluctuation. Bond Exchange Traded Funds (ETFs) with a higher proportion of long dated securities will therefore react more to rising yields than bond ETFs that consists of securities with shorter duration. In terms of shorting treasury ETFs, iShares 20+ Year Treasury Bond (NYSEARCA:TLT) will be a better option than iShares 1-3 Year Treasury Bond (NYSEARCA:SHY) as it typically exhibits higher volatility.

2013

SHY

TLT

JAN

0.04%

-2.06%

FEB

0.05%

0.66%

MAR

0.02%

-0.91%

APR

0.14%

4.57%

MAY

-0.14%

-7.58%

JUN

-0.11%

-2.98%

JUL

0.17%

-1.87%

AUG

-0.07%

-0.47%

SEP

0.31%

1.72%

OCT

0.08%

1.63%

NOV

0.12%

-2.38%

DEC

-0.07%

-1.89%

average return

0.04%

-0.96%

volatility

0.13%

3.02%

Table 6 TLT exhibits more volatility and dropped more in 2013 as the yield curve rose (Source: yahoo finance)

Using monthly returns for the year of 2013 for both SHY and TLT, we can see the latter experienced periods of higher plunges than SHY and provides significant downside opportunity for the potential short trade.

(click to enlarge)

Chart 5 SHY has barely budged while TLT dropped from 117 in April 2013 to 108 in March 2014 (Source: Yahoo finance)

The stock chart comparing SHY and TLT also provides a graphic comparison of the difference in the two ETF's reaction to modestly increasing yields in 2013

Conclusion

The shrinking of the Fed's balance sheet via the maturing of outstanding debt holdings in 2016 will pose upward pressure on long dated rates. This is in fact more significant than the tapering of bond buying program through 2014. Besides the possible raising of fed funds rates will also stress the short end of the yield curve near the fourth quarter of 2014. What the US economy sees as light at the end of the tunnel may turn out to be a freight train heading the way of the Treasury and credit market. Unless China or Japan decides to help fund this $2 trillion funding gap or if the US government is able to reduce this gap via a more austere fiscal policy, the Treasury market looks headed to this potential "creditastrophe". To position for such a possible scenario, opportunities to short the long term treasury segment via TLT should be considered.

Source: The Light At The End Of The Quantitative Easing Tunnel