Fed Exit Means No Pain for Obama as Foreigners Take Up Slack

Treasuries are signaling that the $9 trillion market will weather the end of the Federal Reserve’s quantitative easing program in June without suffering a selloff that drives long-term borrowing cost higher.

The class of investors that includes foreign central banks purchased 60 percent of the $66 billion in benchmark 10-year U.S. notes sold this year, up from 42 percent in 2010. Fed data show banks have increased their holdings of Treasuries to the most since December, as a panel of bond dealers and investors that advises the government says lenders may double their stake to $3.2 trillion in 2016.

Rising demand from international investors and financial institutions bodes well for bonds with the Fed’s plan to buy more than $600 billion of Treasuries more than 80 percent complete. U.S. fixed-income assets are retaining their appeal as the credit quality of European sovereign debt deteriorates and banks meet tighter risk standards governing the capital they need cushion against losses.

“Foreign investors are going to continue to come to the U.S.,” said Robert Tipp, the chief investment strategist for fixed income at Newark, New Jersey-based Prudential Investment Management, which oversees more than $200 billion in bonds. “The liquidity aspect is not to be underestimated. If past is prologue, cessation of large scale asset purchases is likely to prove bullish” for longer-maturity Treasuries, he said.

Losses Slow

Even with the Obama administration selling record amounts of debt to finance a budget deficit exceeding $1 trillion, losses on U.S. Treasuries slowed to 0.14 percent last quarter, from 2.67 percent in the final three months of 2010, according to Bank of America Merrill Lynch index data.

The yield on the benchmark 10-year note rose two basis points to 3.46 percent as of 10:16 a.m. in London, according to Bloomberg Bond Trader prices. The price of the 3.625 percent security due February 2021 fell 4/32, or $1.25 per $1,000 face amount, to 101 11/32.

Treasury 10-year yields will hold below 4 percent through year-end, according to the median forecast of more than 60 economists in a Bloomberg News survey.

Completion of the Fed’s purchases “should have limited effect as net fixed-income supply declines and the demand is picked up by foreign investors and households,” fixed-income strategists at London-based Barclays Capital wrote in a report dated April 1. The firm is one of the 20 primary dealers that trade with the central bank.

‘Little Value’

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., is avoiding Treasuries anyway. Gross, who manages the $237 billion Total Return Fund from Newport Beach, California, said last week in his monthly commentary on the firm’s website that Treasuries “have little value” because of the record U.S. debt burden.

Marketable Treasury debt outstanding has more than doubled from $4.5 trillion in August 2007 at the start of the financial crisis. President Barack Obama’s 2012 budget forecasts the U.S. will run a third consecutive deficit exceeding $1 trillion.

Removing the biggest buyer of Treasuries as the Fed winds down its $600 billion, second round of so-called quantitative easing, or QE2, is bound to drive yields higher, according to Donald Ellenberger, who oversees about $6 billion as co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh.

Inflation Expectations

“We’re getting signals from a lot of members of the Fed that there’s not going to be a QE3, which will lead to yields on Treasuries rising faster than for other debt,” he said.

The Fed voted in November to buy Treasuries to avoid deflation, or a general decline in consumer prices, by pumping cash into the financial system and increasing the flow of credit. Central bank data show it purchased $488 billion of U.S. debt through last week.

Since the vote, inflation expectations as measured by bond prices have risen and the economy has strengthened.

Yields on 10-year Treasury Inflation Protected Securities show investors forecast an average rate of inflation of 2.53 percent during the life of the debt, compared with a 15-month low of 1.5 percent in August. Labor Department data show the economy has created 723,000 jobs while the unemployment rate fell to 8.8 percent last month from 10.1 percent in 2009.

“We could pull up a little bit shy of our total of $600 billion,” St. Louis Fed President James Bullard told reporters at a conference in Prague on March 29. “I think it could be on the order of $100 billion less than what we initially thought.”

End of QE1

In its first round of bond purchases the Fed bought $1.7 trillion of mortgage and Treasury securities in 2009 and the first quarter of 2010. Within three months of that program ending, 10-year yields fell to 2.93 percent from 3.83 percent.

The same may happen again if the absence of the Fed’s cash leads investors to back away from riskier assets such as stocks and speculative-grade bonds, according to Prudential’s Tripp.

Even with the Fed printing cash and the budget deficit exceeding $1 trillion, U.S. assets has attracted investors seeking refuge from Europe’s sovereign-debt crisis, which has forced Greece and Ireland to seek bailouts from the European Union and International Monetary Fund.

The dollar’s share of global currency reserves stood at 61.4 percent at the end of 2010, little changed from 61.5 percent in 2009, the IMF in Washington said March 31. The euro’s share dipped to 26.3 percent from 27.9 percent.

Foreign Holdings

Foreign investors owned $4.45 trillion of Treasuries as of January, up from $3.7 trillion a year earlier, according to the government. China, the largest overseas lender to the U.S., held $1.15 trillion of the debt in January, up from $889 billion a year earlier. Japan’s stake grew 16 percent to $885.9 billion.

Bank holdings of Treasuries and agency debt rose $1.64 trillion as of March 23, approaching the record high of $1.65 trillion on Dec. 1, the Fed said at the end of last week.

A Feb. 1 report by the Treasury Borrowing Advisory Committee, which includes representatives from firms ranging from Goldman Sachs Group Inc. to Soros Fund Management LLC, said demand from banks may total an additional $1.6 trillion through 2016 as regulatory changes require them to add more lower-risk assets to cushion against losses.

The Basel Committee on Banking Supervision, appointed by the Swiss government, proposed rules in October requiring banks to increase available capital and better measure and control their lending risk under the so-called Basel III rules. Banks would be able to hold Treasuries because their safety and liquidity makes them suitable capital under regulations designed to prevent a repeat of the global financial crisis.

Term Premium

A financial model created by economists at the Fed that includes expectations for interest rates, growth and inflation suggests 10-year notes are fairly valued.

The so-called term premium was 0.81 percent on April 1, compared with the 0.7 percent average the past decade. The measure ranged from as high as 1.7 percent in December 2001, just before Treasuries gained 11.6 percent in 2002, to as low as negative 0.51 percent in December 2008, just before they posted a loss of 3.72 percent for 2009.

Investors bid about $2.99 for each dollar available of the $534 billion of notes and bonds sold at government offerings this year, equaling record demand at the 2010 sales, and up from $2.50 in 2009, according to Bloomberg calculations.

Fiscal and monetary stimulus “was a role that the government had to play in the darkest days of the recession and financial markets crisis, and we’re dealing with the repercussions,” said Wan-Chong Kung, who helps oversee more than $100 billion as a portfolio manager at Nuveen Asset Management in Minneapolis. “With economic growth and recovery, it looks like we’re on a sustainable footing, and that should speak well to what the government did and will continue to do.”

Source:  Bloomberg


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