In the middle of the past decade, the Federal Reserve (the Fed) increased the Federal funds rate steadily from mid-2004 through mid-2006 yet 10 and 30-year Treasury yields finished the tightening cycle roughly unchanged. When questioned why interest rates (bond yields) had barely budged Fed Chairman Alan Greenspan was at a loss for words and famously described bond market reaction a “conundrum”.
Similarly, another year of record Treasury issuance kicked off last week with the latest round of 3-, 10-, and 30-year Treasury auctions. Despite conventional wisdom that interest rates will rise with record Treasury borrowing needs, Treasury yields declined by 0.11% to 0.17% on the week, the biggest drop since the Dubai World flight-to-safety rally in late November. The drop in yields occurred even though the week started with an extra security being auctioned, a new 10-year Treasury Inflation Protected Security (TIPS), for a total auction amount of $84 billion. It was only the third time ever the Treasury auctioned four interest bearing securities over four consecutive days, yet all the auctions went relatively well, with each meeting the greater than average demand.
Not only did the Treasury auctions go relatively well but the 30-year bond auction met the strongest demand. The 30-year bond sold at 4.64% yield, nearly 0.05% lower than the yield prevalent at the bidding deadline, indicative of strong demand. Such notable yield drops in the final moments of an auction happened only twice in 2009, in early September and early March. Since the 30-year bond is the most interest rate sensitive Treasury security regularly auctioned, the demand for 30-year bonds sent a strong endorsement of Treasuries across the broader bond market and helped yields fall.
While Treasury supply has garnered more than its fair share of market headlines, a broader look at bond market supply may help explain why increased Treasury supply has not yet led to higher yields. Comparing the outstanding dollar amount of the taxable bond market reveals that while the Treasury market debt outstanding increased a robust 19% from the end of 2008 through the third quarter of 2009 (latest data available), some segments of the bond market actually contracted as a byproduct of the credit crunch. Most notably, commercial paper (included in money markets) and asset-backed securities, two sectors where participants obtained leverage, witnessed the sharpest contraction. Overall, the size of the bond market increased only 3% when considering all the high quality bond options available to investors. This is hardly an onerous supply burden for a bond market that is likely witnessing increasing flows from investors getting back into the market.
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Bond Market Shrinking
However, after taking into account Fed purchases, the bond market actually shrank in 2009. In the bottom table, we adjust the level of bonds outstanding by subtracting Fed purchases through the end of September 2009. After adjusting for Fed purchases, the bond market actually shrank by just over $500 billion, or 2%. The goal of Fed purchase programs was to help the housing market, both by keeping residential mortgage rates low (MBS purchases) and by allowing Fannie Mae and Freddie Mac access to low cost funding (agency and Treasury purchases). Although the Fed bought only government sectors, purchases have helped keep the broader level of interest rates low by reducing the amount of high quality bonds in the marketplace. The 10-year Treasury yield reflects the range-bound trading environment of high quality fixed income markets over the past several months.
Of course other factors, such as low inflation and a Fed on hold, have also played a role in keeping Treasury yields low. Core inflation remains low at
1.8% and is expected to decline in 2010. We expect the Fed to hike interest rates late in 2010 but benign comments from Fed officials over the past
couple months have helped assuage market fears of faster than expected interest rate increases and higher Treasury yields. Based on this we expect the 10-year Treasury yield to rise but remain relatively low in 2010 and finish the year between 4.0% and 4.5%. Still the supply effect should not be dismissed given still strong investor demand for fixed income overall. As we move forward in 2010, the Fed’s impact on the supply dynamic will eventually disappear.
Fed On Target
The Fed is on target to complete their $1.25 trillion Mortgage-Backed Securities (MBS) and $175 billion Agency purchase programs by the end of March. It is possible the Fed extends purchases into April to limit potential market impacts similar to what was done for the Treasury purchase program. However, Treasury issuance will continue unabated for all of 2010. Even if the Fed does not sell existing holdings of Treasuries and MBS back into the bond market, the mere absence of the Fed and its massive buying power will be a negative for the bond market. This is one of the “headwinds” we cited in our 2010 Outlook and may exert upward pressure on bond yields later in the year.
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