from Follow the Money

Can a fall in central bank demand explain the recent rise in Treasury rates?

June 4, 2007

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This week's Economist examines the recent rise in US long-term rates.  The ten-year Treasury bond now yields close to 5%.

I tend to think central bank demand for bonds explains a lot of market abnormalities.   But I don't think the data suggests that a fall off in central bank demand explains the recent rise in Treasury yields.  The New York Fed's custodial holdings of Agencies and Treasuries are still rising at a $40b a month/ $500b a year annual pace -- and last week was particularly strong (hat tip: Global Liquidity Blog).  It is hard to square record growth in the custodial holdings of foreign central banks with a fall in central bank demand for US debt. 

True, the creation of investment funds may lead to fall in demand for bonds relative to other assets.  But the pace of reserve growth has accelerated more rapidly the pace of government decision-making.   Sure, China invested $3b in Blackstone.  But $3b is about two days worth of China's typical bond purchases.   It hardly makes a dent in the overall numbers.   Talk about the impact of investment funds on markets is running well ahead of actual flows into investment funds.

Central banks do seem to be buying a lot more Agencies this year. It is a bit beyond my area of expertise, but I suspect that what matters for US rates is total central bank demand for US debt, not the distribution of that demand between  the Agency and Treasury market.  Treasuries and Agencies are close substitutes.  Plus central banks are still net buyers of Treasuries, not net sellers -- rather than a fall in demand for Treasuries, there really has been a surge in demand for Agencies.  

The core reason for the rise in bond yields is pretty simple.  The market no longer expects the Fed to cut by much.  And, as the Economist notes, the recent surge in corporate issuance hasn't pushed corporate spreads up, which does suggest very strong demand for corporate debt.

Central banks may be contributing to that.  Directly, as they reach for yield.  And indirectly, as pension funds and others who sell Agencies to central banks look for new investments that offer just a bit of a yield pick-up.  Read El-Erian (hat tip, Felix Salmon).   As he correctly notes, those betting on a continuation of " historical aberrations in market trends have continued to benefit."   One aberration is the low spread on corporate debt.  But betting on the continuation of that aberration has been more profitable than betting on a reversion to the mean.  

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