Will the Fed's tapering and ending of its quantitative easing (QE) program lead to a collapse in the Treasury bond market? Given the Fed's aggressive purchases of long-term Treasuries, many market commentators expect the withdrawal of this support to lead to a large excess supply, resulting in a sharp increase in long-term Treasury yields. This dynamic has been evident in the last month after revived speculation on Fed tapering prompted the 10-year yield to spike from about 1.60% to 2.20%.
However, a closer look at near-term supply and demand reveals that this excess supply scenario will not play out in the next few years. I collected the numbers on Treasury bond supply and demand, and I found results that challenge this commonly held view.
Summary of key findings
- Both the Fed and the foreign official sector have played a large role in the U.S. Treasury market. It is not all about the Fed.
- This role is particularly significant for longer maturities, so it is important to distinguish between all Treasuries vs. only long-term Treasuries if we are interested in long-term rates.
- The rapidly shrinking Federal budget deficit is reducing Treasury issuance by almost one half in 2013.
- In spite of large budget deficits, the private sector has been a net seller of long-term Treasuries since late 2010. This will continue until about mid-2014.
- Even when the Fed tapers and ends its QE program, the private sector will not need to step in to buy new long-term Treasuries. By that time the deficit will have fallen enough that the new supply will be almost entirely absorbed by the foreign official sector.
- In the second half of 2013, the Fed will actually buy over 200% of the new Treasury debt supply, which is twice as large a share as in 2011-2012. This should put some downward pressure on rates in the near future.
Issuance of Treasury debt is shrinking
The U.S. federal deficit is declining at a rapid rate: the annual net issuance of marketable Treasury debt is projected to fall from over $1.1 trillion in calendar year 2012 to about $600 billion in 2013. This is due to sequestration, rising tax receipts, and unexpectedly large payouts by Freddie Mac and Fannie Mae. Figure 1 shows the annual debt issuance of all marketable Treasury debt and long-term debt only (maturity over 5 years). The total debt issuance is from the CBO's May 2013 projections, and the long-term debt issuance is inferred from the total. (Sources: CBO, U.S. Treasury)
Figure 1. Annual issuance of U.S. Treasury securities.
Both the Fed and the foreign official sector are buying
Since late 2010, both the Fed and the foreign official sector have been large buyers at the long end while the private sector has actually been a net seller of Treasuries, in spite of the large budget deficits and new debt issuance. Figure 2 shows the long-term Treasury holdings of all three groups, indicating that this trend will continue for another year. (Sources: U.S. Treasury, Federal Reserve, CBO, author's calculations)
These future projections are based on a simple linear trend for the foreign official sector. The Fed Treasury holdings (across all maturities) are assumed to increase at the current pace of $45 billion per month until the September 2013 FOMC meeting, then taper to $25 billion per month, and finally stop altogether at the June 2014 FOMC meeting. (Note that not all the Fed purchases are targeted at maturities over 5 years; these projections take this into account.) This is intended to be a conservative estimate, meaning that the actual Fed QE purchases will probably be at least as large as assumed here.
Figure 2. Holdings of long-term Treasuries by the Fed, the foreign official sector, and the private sector.
The private sector will not have to step up as a buyer
Figure 3 shows the flow of purchases using the same data. In 2013, the Fed is projected to buy long-term Treasuries at a rate of $291 billion while the net long-term issuance falls to only $123 billion. With the foreign official sector buying $96 billion, the private sector is selling at an annual rate of $264 billion.
Interestingly, when the Fed ends its asset purchases, the deficit is projected to have fallen enough that the foreign official sector can absorb almost all of the new supply. So there will be essentially no need for the private sector to start buying long-term Treasuries even after the end of QE! The private sector may no longer be a net seller, but it will likely not be a net buyer either.
Figure 3. Annual issuance and purchases of long-term Treasuries.
Fed purchases still to peak before tapering
Looking at the flow of purchases relative to the new supply (Figure 4), we see that the Fed is actually becoming an even larger buyer toward the end of 2013 as the deficit shrinks faster than the Fed's asset purchases. The Fed will momentarily buy over 200% of new long-term Treasury supply, with the private sector having to step in to supply the additional securities. This could well mean downward pressure on rates until supply matches this price-insensitive demand. That pressure will then decrease at the end of 2013, unless the Fed waits longer than its September meeting to announce its tapering of the asset purchases.
Figure 4. Purchases of long-term Treasuries as a share of net new issuance.
Market consensus too gloomy for long-term Treasuries
Naturally the supply and demand situation is not the only driver of long-term Treasury yields, but given the large volumes involved, it is not insignificant either. The focus on the Fed is certainly justified, but this may have led many market commentators to ignore the other two drivers of supply and demand, namely the trend in foreign official sector purchases and the rapidly shrinking budget deficit. This in turn suggests that today's market consensus is likely to be excessively gloomy for long-term Treasuries.
Sources: U.S. Treasury, Federal Reserve, CBO, author's calculations
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular. This material does not constitute an offer or solicitation to sell or a solicitation of an offer to buy any shares of any Fund (nor shall any such shares be offered or sold to any person) in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction.