(Bloomberg) — A shift in guard among the biggest buyers of U.S. Treasuries has Wall Street veterans bracing for more pain in the world’s largest bond market.
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Fixed investors, including foreign governments, US commercial banks and the Federal Reserve, remained largely absent. In their place, hedge funds, mutual funds, insurers and pensions are piling up. Market watchers note that unlike their price-agnostic predecessors, the new buyer base is likely to command a premium, especially to support Washington’s spending habits. With the sale of debt, the deficit will grow.
As Treasuries plunge into a third consecutive year of declines and the 10-year yield climbs to its highest level since 2007, more volatility and more losses — especially for long-dated bonds — are on the horizon, they warn. Produce directly affects everything from mortgage rates to corporate borrowing costs. That’s bad news for the U.S. economy, which is struggling to avoid a recession as early as next year.
Ray Dalio, founder of Bridgewater Associates, said: “We have an unusual supply-demand situation because of the amount of debt the government is selling. David Westin of TV. Dalio, like Wall Street titan Larry Fink, said he expects the 10-year yield to rise above 5% in the near future. “Buyers are less interested in buying the debt, for a variety of reasons,” including “a lot of it’s gone bad. There’s a lot of losses.”
Of course, some argue that the retreat of central banks, and particularly the Fed’s reduced role in the market, is more a return to normality after years of weakened liquidity and frozen volatility.
The ICE BofA MOVE Index, which tracks price changes in U.S. bond options, averaged a reading of 124 last year, nearly double the previous decade’s high and close to the 50-year average.
Further activity could help restore investor confidence in the Treasury market as a leading indicator of economic volatility following years of mixed signals.
Still, it’s cold comfort to associate struggling bulls with record Treasury losses. Ten-year yields touched 4.89% last week, the highest in more than 15 years, before ending Thursday at 4.7% for the week in dramatic swings.
One key buyer will be hedge funds. Firms such as Citadel and Millennium Management have been active this year in both fundamentals trading and leveraged trading. Holdings of U.S. government bonds in the Cayman Islands, home to more hedge funds than anywhere else in the world, are near record highs, Treasury Department data shows through the end of July.
Fast money funds aren’t the only ones raising their stakes. According to JPMorgan’s mid-year outlook, mutual funds will generate $275 billion in net Treasury outflows this year, a nearly 14-fold increase from 2022, while pensions and insurers will buy another $150 billion, the highest since 2017.
But this desire comes at a cost.
At JPMorgan Chase & Co. “These are more value-conscious buyers, so it’s going to be difficult to find that balance at a reasonable price,” Jay Barry, head of U.S. pricing strategy, said in an interview. “This will lead to higher premiums and a steeper yield curve over time.”
Read more: How rising rates, US debt brought term premiums: QuickTake
On the other hand, foreign holdings as a share of the US national debt have been shrinking for some time, falling to 27% earlier this year, the lowest since 2002, according to Fed data. Japanese issuers, historically among the most active buyers of U.S. government bonds, will face higher hedging costs, especially as the yen weakens this year.
Lately, U.S. commercial banks have been unloading Treasuries amid a sharp decline in deposit balances. Treasuries and non-mortgage agency debt, net of government securities, fell to $1.5 trillion last month from a record high of $1.8 trillion in July 2022, Fed data showed.
And then there’s the U.S. Federal Reserve’s quantitative tightening program, which allows up to $60 billion in Treasury bills each month. The stock of government debt fell to $4.9 trillion from last year’s peak of $5.8 trillion.
Jean Boivin, a former Bank of Canada official and head of the BlackRock Investment Institute, said: “The previously static buyers – central banks, foreign investors and banks – are now working again.” “The Fed’s quantitative tightening means other buyers will become more important.”
This week’s weak bids were capped by a selloff in the uncapped 30-year bond, which sold at a higher yield than the market on Thursday, a sign of softer demand.
Treasury-market headwinds
The volatility in demand comes as the U.S. deficit is expected to rise to $1.52 trillion in the 11 months to August.
Among investor spending, the amount of marketable U.S. debt has reached more than $25 trillion, an increase of roughly 50 percent since the start of 2020. 1 1/2 years, and most Wall Street traders predict further increases in auction volumes over the next two quarters.
More importantly, the government’s debt service costs have risen sharply, rising to about $600 billion a year because of the Fed’s interest rate hikes, which now account for 14 percent of tax revenue.
“Supply — especially relative to demand — looks like it’s getting very serious,” said Gennady Goldberg, head of U.S. price strategy at TD Securities Inc. If the macro is not defeated. And if we’re stuck here longer than we expect – at these rates – and there’s no recession, then supply winds will become more and more relevant and influential.
For many, the impact is already visible.
The Fed’s benchmark term premium rose more than a percentage point over the past three months, turning positive for the first time since 2021 and marking a dramatic increase in long-term rates.
The spread between two-year notes and 10-year bonds, a common measure of the yield curve, also rose over time (though still negative), indicating investors are asking more to lock up their money for longer periods.
“We need to connect with a different buyer base for Treasuries,” said Priya Misra, portfolio manager at JP Morgan Asset Management. “The buyer of margin treasuries will be asset managers. And since these buyers are more price and flow sensitive, this means more volatility. Foreign central banks had to invest their reserves and banks had to liquidate their deposits. But asset manager demand is a function of income flow and performance of various asset classes.
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