It has been a source of concern for the Treasury bears for months: Who is going to fill the void in demand for U.S. Treasuries left behind by the Fed once QE2 comes to an end? The quick answer is that current stock investors will be the likely source, and they have the ammunition to fill the gap and much more in the coming months.
The question makes a ton of sense, as the Fed has been in the process of purchasing $600 billion in U.S. Treasuries since November 2010. And during this time, we’ve seen 10-year Treasury yields climb from below 2.50% to above 3.70% in recent months. So what than is going to happen to Treasury yields once this $600 billion buyer, the Fed, goes away? But instead of climbing higher, yields are likely to fall in the coming months, and prices will rise. Meanwhile the capital flows redirected from the stock market are a likely to be a driver of this trend.
When QE2 was announced in August 2010, and finally launched in November 2010, it sent an explicit signal to investors to sell Treasuries and buy stocks. The Fed made it crystal clear that part of the emphasis of QE2 was to boost stock prices with the idea of creating a wealth effect that would filter its way through to stimulate the overall economy.
Thus if you were invested in Treasuries last November, particularly with yields south of 2.5% at this point, you were given a blaring signal to sell your Treasuries and get on board with stocks for a QE driven float higher. This rise in stocks was likely to occur regardless of whether the underlying fundamentals supported it, which of course they haven’t in the months since, as evidenced once again most recently by Friday’s job report.
So what did investors do last November with the start of QE2? They closed out their Treasury positions and bought more stocks. That left the Fed as the primary buyer left in the market, and that still wasn't enough as yields began to rise.
The market capitalization of stocks has ballooned since the mere idea of QE2 was introduced last summer. Over the past year the combined market cap of the New York Stock Exchange and the NASDAQ has increased from $15 trillion to $19 trillion. This is an increase of $4 trillion and this is a measure of the U.S. stock market only, and does not capture all of the money that flowed into non-U.S. stocks and commodities over the past year. Even if you focused on the U.S. stock market, $4 trillion is a heck of a lot more than the $600 billion gap left behind by the Fed in the Treasury market.
Two Key Factors Have Already Been Compelling Investors Out of Stocks and Back to the Treasury Markets:
First is anticipation. A fact that was not lost on many investors is that U.S. Treasury performance was lousy throughout QE1, and strong once QE1 came to an end. Although Treasury performance turned lousy again once QE2 got started, investors have been anticipating for months that Treasuries may rally anew once QE2 came to an end. As a result we’ve seen Treasuries moving higher, going all the way back to February 2011, and I have been among the buyers along the way.
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Second is flight to safety. Investors have enjoyed an exceptionally strong run in stocks since the March 2009 lows, and the only time the stock rally was disrupted in any meaningful way was last summer when the QE spigot was turned off. Unfortunately for stocks the pace of economic recovery has been insufficient to support the advance to this point, leaving a good deal of air under the market at current levels. Stocks are forward looking, and the magnitude of the rally to this point has been predicated on the idea that the economy would be stronger and still accelerating at this point.
Instead the pace of the recovery remains sluggish, and recent data trends are decelerating. This has culminated at a time when the European sovereign debt crisis continues to deepen. All of these forces bode ill for the stock outlook, particularly with equities now 40% overvalued relative to historical long-term valuations. These factors are also disinflationary if not outright deflationary, which conversely bodes well for Treasuries going forward.
It’s been a great run for stocks, and the current rally appears set to take a final curtain call, but given the prevailing risks it would not be a surprise to see investors look to lock in profits and move to safety. Although the long-term outlook for Treasuries is certainly challenging, Treasuries remain among the most favored locations to park capital during times of economic and stock market tumult. And with $4 trillion plus in market capitalization built up over the past year it is more than reasonable to think that at least 15%, or $600 billion, of this amount if not much more could find its way back into Treasuries in the coming months.
Two Final Points:
- Positions in Treasuries under this theme should be viewed as short-term holdings. While the current economic and stock market backdrop may be favorable for Treasuries, the long-term fiscal outlook in the U.S. remains deeply challenged. With yields already at historically low levels, at some point we will see yields begin to make a secular shift higher, but this is unlikely to occur in the near-term as disinflationary/deflationary forces appear likely to win out instead at this point.
- Stay closely tuned to the current debt ceiling debate. While resolution remains likely if the debate were to take an unexpectedly nasty turn and policy makers suddenly begin realistically entertaining the idea of default; all bets are off for stocks, bonds or anything else for that matter. Again, this is highly unlikely, but something that should be watched closely just in case.