Chandler Bond Market Review

Treasury Debt: How Much is Available for Private Investors?

As we have discussed in our previous commentary, the available supply of safe-haven assets has dwindled for investors. The tenuous global economic backdrop has contributed to the lack of safe, sovereign assets as the debt of peripheral European countries are no longer perceived as “risk free”. China does not have a developed global bond market and Japan finances their deficit via the domestic economy, and thus neither represents realistic substitutes for global safe-haven flows. In the current investment environment, arguably the only two sovereign markets with the depth, safety, and transparency to be considered risk free are German Bunds and US Treasuries. Investors covet safe-haven assets, particularly in times of heightened uncertainty, yet there are fewer such assets available on a global basis.

Recently, domestic market sentiment has been strongly impacted by political developments. As part of the fiscal cliff negotiations that concluded at year-end, existing tax rates were extended for the majority of the population. However, significant milestones remain in the coming quarter, including the extension of the debt ceiling above $16.4 trillion, the government’s actions on the impact of sequestration, and the continuing spending resolution for 2013 (which runs out at the end of March). We analyze the changing Treasury debt investment landscape from the perspective of fiscal policy and developments, economic issues, and the Federal Reserve’s objectives.

The level of conventional monetary stimulus being injected into the US economy remains high, and this is unlikely to diminish in 2013. The Fed Funds rate will continue to be pegged at 0.25%. Unconventional monetary policy, primarily the expansion of the Fed’s balance sheet to promote employment (Quantitative Easing), will also remain highly stimulative, but for a less certain timeframe. On the other hand, fiscal policy will likely have a negative effect on the economy, with numerous tax provisions expiring and spending cuts expected to be part of the ongoing negotiations. We anticipate the level of fiscal support for the economy to decline this year.

The Federal Reserve is currently on its fourth iteration of Quantitative Easing (QE4), and the latest consensus estimate for the size of the Fed’s balance sheet at the end of 2013 is nearly $4 trillion (see Chart 1). For perspective, at the end of 2012, the Fed’s balance sheet was valued below $3 trillion, and prior to the financial crisis it was at less than $800 billion. This expansion of the Fed’s balance sheet will likely create an inflation problem in the future. Nonetheless, based on the high unemployment rate and the perceived excess capacity within the US economy, the Fed continues to look past the negative implications of a large balance sheet and the monetary stimulus embedded within.

Chart 1

The other potential safe-haven sector in the US, government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, remain under conservatorship by the US Treasury and are required to shrink their retained portfolios by 15% per year beginning in 2013 (as compared to the previous requirement of 10% per annum). As the supply of GSEs continues to contract, the historically attractive yield enhancement from owning Agencies versus Treasuries will continue to trend downward.

Despite an estimated net Q1-2013 issuance of just over $500 billion in US Treasuries, the net amount of new Treasury coupon supply (excluding TIPS and T-Bills) available for the market to absorb is far less. Approximately $300 billion in US Treasuries will mature and the Fed’s QE program anticipates purchases of more than $130 billion, leaving slightly more than $60 billion net new supply for the market (as shown in Chart 2).  Thus, even though the US government continues to accumulate large deficits and continues to fund those deficits through issuance of Treasuries, the impact on the net supply to the market has been negligible. With meager net supply far exceeded by normal market demand, the yield on US Treasuries will likely stay close to its current low levels.

Chart 2

Based on the most recent quarterly projections of the Federal Reserve, the committee’s long-term goals for unemployment and inflation are 5.2-6.0% and 2.0%, respectively. The Fed has also communicated it is willing to accept inflation running above its 2.0% target, provided that the unemployment rate remains above 6.5% and long-term inflation expectations remain “anchored”. We foresee the FOMC will continue actively distorting asset prices—to the detriment of fixed income investors—by keeping the yield on Treasury securities artificially low (see Chart 3).

Chart 3

The current supply of new issues confirms the Fed is disproportionately purchasing Treasury assets further out on the yield curve, where investors typically extract the most concession when inflation expectations increase. Chart 3 shows that in the 10-30 year maturity range, demand almost equals supply (when taking QE4 into account). The Treasury issuances available to investors are much greater with shorter maturities. With the Fed actively choosing to purchase longer term issues, they are also actively constraining investors’ opportunities to take a bearish view on long-term inflation expectations.

Despite the significant amount of quarterly US Treasury issuances, rates are unlikely to increase significantly with the Fed’s latest iteration of QE. In conclusion, our analysis of fiscal policy and developments, economic issues, and the Fed’s goals, confirm the estimated net quarterly supply of $60 billion is not nearly enough to alter current market dynamics. Private investors may need to seek out alternative investment vehicles due to a shortage of Agencies and Treasuries.

 

– William Dennehy, II, CFA
   Portfolio Manager

Source for charts: US Treasury and Federal Reserve

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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