The Treasury market, in a world no longer dominated by central bank reserve managers

In case you haven’t heard, the Treasury market – and the mortgage market -- had a bad day. Ten-year Treasury yields are back at their November 2008 levels (long-term Treasury yields didn’t fall immediately after Lehman). 3.7% for ten year money isn’t all that high a rate. Especially for a country with a substantial fiscal deficit. But it isn’t 2% either.

What happened?

In very broad terms, rising supply met falling demand from one important subset of the market. Bringing in new (private) money has required higher yields.

The supply of longer-term Treasuries is increasingly rapidly. Until I looked closely at the data – from the monthly statement of the public debt -- I hadn’t realized that the big increase in outstanding supply of longer-dates Treasuries only really came in 2009. The surge in Treasury issuance in 2008 was almost entirely short-term bills.

Over the last 12 months of data (data through the end of April, May data will be out soon), the US issued $735 billion of notes, bonds and TIPs.* In calendar 2008, the increase in supply of longer-term Treasuries was about $400b – a large sum, but easily within the realm of historical experience.

Yet even as the supply of notes has increased, central bank for longer-term Treasuries for their reserves has fallen. Central bank demand for longer-term Treasuries – on a rolling 12m basis – has been trending down since August 2008.

That has meant that private investors have had to absorb almost all of the growth in supply. That is a noticeable change. Central bank reserve demand more or less matched the increase in note supply in 2006; it exceeded the increase in supply in 2007.

Looking at the 12m change actually understates the swing in central bank demand. In the first quarter of 09, the outstanding stock of longer-term Treasuries rose by $278 billion. Central banks – according to the Treasury data – only bought $25 billion of longer-term Treasuries (all in March, and likely mostly short-term notes). China only bought $15 billion (all in March). Over that time period, central banks bought $85 billion in short-term Treasury bills, including $32 billion from China.

Since the first quarter, the scale of long-term issuance has only increased. Central banks aren’t just buying bills anymore, but they still prefer the shorter-maturities. Treasury market blogger Jansen:

Foreign central banks continue to intervene, buying dollars and selling their local currencies. The names most mentioned in that endeavor are Russia and Brazil. Sources tell me that the fruits of the intervention are parked in 2 year notes and 3 year notes. There is a dearth of central bank interest in the longer maturities.

Foreign central banks continue to intervene, buying dollars and selling their local currencies. The names most mentioned in that endeavor are Russia and Brazil. Sources tell me that the fruits of the intervention are parked in 2 year notes and 3 year notes. There is a dearth of central bank interest in the longer maturities.

Other things have changed too. The expected level of public debt in 2015 is higher now than a year ago. American households stopped buying cars and started saving. The global economy slowed dramatically. Industrial production is down, and spare capacity is up. Inflation is down. As is expected inflation (from TIPs yields), though not as much as in the fall. The Fed’s balance sheet is larger, and expected to get still larger.

My guess though is that central banks’ shift toward shorter maturities has had an impact on the market.

Relative to a lot of models – including say Goldman’s model – ten-year yields were lower than they would have been expected to be back when central bank demand topped issuance.

Now, not so much …

Domestic US holdings of Treasuries are actually quite low relative to US GDP. Even now. Relative to the early 1990s – when debt to GDP levels were comparable to current levels – more Treasuries are held abroad. But after a long period when Treasury issuance lagged central bank demand (to such an extent that central banks were pushed into Agencies), the US is entering an era where domestic holdings of Treasuries will have to rise, absolutely and relative to GDP.

One aside: total Treasury issuance over the last 12 months of data was over $1.6 trillion. The market has already demonstrated that it can absorb a very large increase in supply. This was – obviously – a period of financial stress, which helped increase Treasury demand. It was also a period when the Fed was a net seller of Treasuries, not a net buyer. For most of 2008 the Fed was selling its Treasury stockpile to finance its lending to troubled financial institutions. It only started buying recently. That is one reason why it isn’t obvious to me that the total amount of Treasuries the private market will need to absorb over the next 12 months will be substantially higher than the amount it has absorbed over the last 12 months. However, the composition of new Treasury issuance is likely to continue to shift, so the amount of longer-term Treasuries the market will need to absorb will continue to rise. And of course a sustained deficits do produce a large rise in the outstanding stock ...

Note: Paul Swartz and Arpana Pandey of the Council on Foreign Relations Center for Geoeconomic Studies helped gather the underlying data used in this analysis. The Center for Geoeconomic Studies is also now putting out a chartbook showing how the the BRIC countries foreign exchange reserves compare with their US holdings . This publication draws on the work Arpana Pandey and I have done tracking global capital flows. Check it out.

*Treasury bills generally do not pay a coupon and have a maturity of a year or less. Treasury notes have a coupon and generally have an initial maturity of between one and ten years. Bonds have a maturity of over ten years. TIPs are Treasury Inflation Protected Securities; their principal adjusts along with inflation.