By Gary Halbert
Back in December when the Fed started its “tapering” operation, with the goal of terminating it by the end of 2014, it was only natural to assume that the Fed’s retreat would result in higher yields this year, especially on long-maturity Treasuries and mortgage-backed securities (MBS).
After all, the Fed has been the largest buyer of Treasuries and MBS in the history of the world since it began its “quantitative easing” (QE) program in late 2008. At that time, the Fed had apprx. $750 billion worth of Treasuries and MBS on its balance sheet. Today, that number is north of $4 trillion! Of this amount, over half ($2.4 trillion) is in long-dated Treasuries. QE has been the largest central bank asset purchase program ever recorded by far.
By late 2012, the Fed’s purchases of long-dated Treasuries and MBS climbed to a staggering $85 billion per month – just over $1 trillionadded in 2013 alone. The Fed has been reducing these monthly asset purchases by $10 billion at each policy meeting since last December. Following the last policy meeting on June 17-18, the Fed’s QE purchases are now down to $35 billion per month. The plan is that these purchases will wind-down to zero before the end of this year.
Virtually every forecaster I read predicted that the Fed’s withdrawal from QE would result in higher interest rates for long-dated Treasuries and mortgage rates. Yet to the surprise of just about everyone, longer-term Treasury yields have plunged this year.
The Problem: A Shortage of Long-Dated Bonds
One reason that Treasury yields have fallen significantly this year is that there is a shortage of long-dated Treasuries. The Fed is partly to blame. Through its massive QE purchases of Treasuries and MBS, the Fed now owns about 20% of all Treasuries, or $2.4 trillion. Banks, on the other hand, hold only $547 billion of tradable Treasuries and government agency-related debt.
In addition, the Fed’s holdings have shifted in ways that leave fewer central-bank-owned Treasuries available to be borrowed. This shift was caused by “Operation Twist” during the November 2011 to December 2012 period when the Fed sold shorter-dated Treasuries and bought more longer-dated bonds, which reduced the available pool of long bonds even more.
Adding to the problem, major US banks have also increased their purchases of Treasury debt, in part due to the Dodd-Frank law that was supposedly designed to limit risk taking by large US banks. Demand for Treasuries from large pension funds and foreign investors has also increased this year. Also, some of the outsized gains from the stock market last year have made their way into Treasuries.
Finally, the government itself has been selling fewer Treasuries in recent years as the federal budget deficits have fallen significantly. During the Great Recession, budget deficits ran over $1 trillion a year. The budget deficit for FY2012 was $1.1 trillion. However, in FY2013 the deficit fell sharply to $680 billion, down 37%.
For FY2014, the Congressional Budget Office estimates that the deficit will fall even further to $492 billion, and many believe it will be closer to $400 billion, as the economy shows more signs of strength. For FY2015, the deficit is expected to be $462 billion or less.
The point is, with budget deficits less than half of the $1 trillion or so that they were in President Obama’s first term, the government is selling less than half the amount of Treasuries it was just a few years ago. This, too, adds to the shortage of Treasuries.
The bottom line: When Treasuries are in short supply and demand is strong
as it has been this year, buyers bid up the prices of these securities. When
bond prices go up, yields fall.
This helps explain why interest rates have come down this year at a time when almost everyone expected them to rise. It also explains why the Fed would like investors to sell their bonds to help alleviate the shortage. Of course, Fed Chair Janet Yellen would never say that!
It remains to be seen if this trend of lower interest rates will continue as the economy gathers momentum. While I didn’t mention it above, no one expected the economy to tank 2.9% in the 1Q and this, too, helped bring interest rates down more than expected.
As you can see in the chart above, the 30-year T-bond yield bottomed in late May at 3.30% and has been rising since then. If the first estimate of 2Q GDP comes in above 3% on July 30, I would expect that we’ve seen the bottom in long rates for this cycle.
Update: for a deeper look at this issue, click here for an Zero Hedge article on this topic.