Bloomberg News

Dealers Tighten Treasuries Grip as New Fed QE3 Suppresses

December 24, 2012

Dealers Tighten Treasuries Grip as Fed QE3 Suppresses Yields

Trading of Treasuries among the primary dealers has averaged $522 billion a day this year, according to the Fed. Photographer: Dermot Tatlow/laif/Redux

The world’s biggest bond dealers are growing more reluctant to give up their record holdings of Treasuries, providing support for a rally in the world’s most- liquid debt market that is entering its fourth year.

Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of the 21 primary dealers of U.S. government securities have reduced the amount of bonds they offered to the Federal Reserve to average of $8.04 billion a day in the past two weeks, from the $11.6 billion in September 2011, when the central bank began its Operation Twist stimulus program, according to data compiled by Bloomberg. At the same time, Wall Street’s holdings of Treasuries more than doubled since March.

The hoarding shows rising demand for the safety of U.S. government debt as economic growth remains sluggish and President Barack Obama and House Republicans struggle to resolve the budget dispute that threatens to trigger more than $600 billion of spending cuts and tax increases in January.

“The market continues to be held hostage by politics and the economic numbers aren’t that strong,” Matthew Duch, a fund manager in Bethesda, Maryland, at Calvert Investments, which oversees more than $12 billion in assets, said in a telephone interview Dec. 20. “In this environment, where you have fewer and fewer options, you have to align yourself with what the Fed is doing. You can’t afford not to.”

Bond Rally

The yield on benchmark 10-year Treasuries was at 1.78 percent as of 10:10 a.m. London time after sliding three basis points on Dec. 21. The price of the 1.625 percent security due in November 2022 was at 98 23/32, according to Bloomberg Bond Trader prices. Trading in Treasuries ends at 2 p.m. New York time and will remain closed Dec. 25, according to the website of the Securities Industry and Financial Markets Association.

Treasuries have returned 2.1 percent in 2012, including reinvested interest, Bank of America Merrill Lynch indexes show.

U.S. government debt fell last week, pushing 10-year yields up six basis points, or 0.06 percentage point, to 1.76 percent, according to Bloomberg Bond Trader prices. That compares with 1.88 percent at the end of last year and the average of 7 percent the past 40 years.

Yields are poised to end 2012 lower than they started for a third consecutive year, the longest streak since 2002, underscoring relentless demand even as Treasury Department data show total marketable U.S. government debt has risen to a record of $11 trillion.

Trading of Treasuries among the primary dealers has averaged $522 billion a day this year, according to the Fed.

Record Bids

Investors have bid a record $3.16 for each dollar of the $2.011 trillion in notes and bonds the government has auctioned this year, up from the previous high of $3.04 last year, Treasury data show.

Banks submitted offers equaling $2.61 for each $1 of securities purchased by the Fed for its expiring $667 billion stimulus program, known as Operation Twist, where the central bank swaps short-term debt it owns for an equal amount of long- term Treasuries. That’s down from the weekly average of $2.99 since September 2011, according to data compiled by Bloomberg.

The primary dealers that trade with the Fed boosted holdings of Treasuries to $136 billion from this year’s low of $59 billion in March, central bank data shows. Inventories of government securities averaged $90.4 billion in 2012.

Investors have poured about $302 billion into bond mutual funds while withdrawing $135 billion from those that favor equities, according to data from the Washington-based Investment Company Institute.

Biggest Buyer

The Fed has been the biggest buyer of U.S bonds, flooding the economy with more than $2.3 trillion through three rounds of purchases since the depths of the financial crisis in 2008. It’s now the biggest owner of Treasuries, with $1.66 trillion as of this month, ahead of China’s $1.16 trillion.

“On top of the Fed’s purchases, a year full of uncertainty made people more reluctant to offer Treasuries to the Fed,” George Goncalves, head of interest-rate strategy at primary dealer Nomura Holdings Inc., said in a Dec. 18 telephone interview. “Until the hurdles that are keeping rates low are lifted we will continue to trade in a very tight range.”

Returns for Treasuries this year follow gains of 9.8 percent in 2011 and 5.9 percent in 2010. That compares with 16 percent total return for the Standard & Poor’s 500 stock index (CRY), and an 11 percent return for company bonds as measured by the Bank of America Merrill Lynch Corporate & High Yield Index. The Thomson Reuters/Jefferies CRB Index of raw materials has lost 3.7 percent.

Yield Forecasts

With yields so low, the best may be over for bonds. Ten- year rates will rise to 1.88 percent by the end of June 2013, and to 2.17 percent at year end, according to median forecasts in a Bloomberg survey of analysts.

Investors increased bets to the most since June that Treasuries will drop, according to a JPMorgan weekly index. The proportion of investors who had a net short position, or wagers the securities will fall in value, was 6 percentage points in the week ending Dec. 17, compared with net longs of 17 percentage points in August.

Rates on 10-year notes have risen when the Fed begins so- called quantitative easing programs that pump money into the financial system through bond purchases because of optimism the moves will spur growth and inflation.

After the first $300 billion stimulus was proposed in March 2009, yields climbed to the year’s high of 4 percent in June. They rose to a 2011 high of 3.766 percent on Feb. 9 following the Nov. 3 announcement of the $600 billion QE2 program.

Growth, Spending

“The economy is already starting to improve and by stimulating the economy further it is likely to lead to higher levels of economic growth, and as such higher interest rates are to be expected,” Scott Minerd, the chief investment officer of Guggenheim Partners LLC, said in a Dec. 12 telephone interview. The Santa Monica, California-based firm oversees more than $160 billion.

U.S. gross domestic product grew at a 3.1 percent annual rate in the third quarter, faster than the 2.7 percent earlier estimated by the government, according to Commerce Department figures. Consumer spending increased 0.4 percent in November after a 0.1 percent drop in October, the department said Dec. 21.

DoubleLine Capital LP Chief Executive Officer Jeffrey Gundlach recommends holding cash and waiting to buy riskier assets at lower prices as each step of government stimulus brings fewer benefits.

“There seems to be diminishing returns” on each successive round of QE, Gundlach, whose $36.8 billion DoubleLine Total Return Bond Fund returned 9.1 percent this year, beating 97 percent of peers, said in an Dec. 18 Bloomberg Television interview. “It’s almost like a half-life of a radioactive particle.”

Fed Outlook

The Fed said Dec. 12 it will keep the target rate for overnight loans between banks at about zero and buy U.S. bonds at least as long as unemployment remains above 6.5 percent and inflation between one and two years ahead is expected to be no more than 2.5 percent. Policy makers forecast unemployment won’t fall to between 6 percent and 6.6 percent until 2015.

Employment rose by 146,000 jobs in November and the jobless rate fell to 7.7 percent, the lowest since December 2008. Average hourly wages increased 1.7 percent from a year earlier, down from a four-year high of 3.7 percent in January 2009.

The central bank’s preferred measure of inflation, the personal consumption expenditures index, rose 1.5 percent in November from a year earlier. The broader consumer price index gained 1.9 percent, the Labor Department said Dec. 14.

Fed Dominance

Purchases by the Fed will effectively absorb about 90 percent of net new dollar-denominated fixed-income assets, according to JPMorgan. The government will reduce net sales by $250 billion from the $1.2 trillion of bills, notes and bonds issued in fiscal 2012 that ended Sept. 30, according to 18 of the 21 primary dealers.

More stimulus would be needed next year should U.S. leaders fail to avert the so-called fiscal cliff, set to start in January. The Congressional Budget Office has said that without a budget agreement, the economy would probably slide back into a recession in the first half of 2013. If Congress doesn’t act, tax rates for income at all levels would rise next month, along with taxes on estates, capital gains and dividends.

“Whatever comes out of the fiscal debate will likely be contractionary, which should be supportive of U.S. government bonds,” Christopher Sullivan, who oversees $2 billion as chief investment officer at United Nations Federal Credit Union in New York, said in a telephone interview Dec. 18.

Politicians are struggling to reach a deal to avert the mandated tax increases and spending cuts due to begin Jan. 1.

A vote on House Speaker John Boehner’s plan to allow higher tax rates was canceled late last week because of resistance from within his own party, the Ohio Republican said in a statement.

‘Staying Aggressive’

Boehner told reporters that members of his caucus refused to back it because they didn’t want to be accused of raising taxes. His decision means lawmakers won’t vote until after Christmas. Until Dec. 17, Obama and Boehner had been edging closer to a deal that would have included $1 trillion each in tax increases and spending cuts.

The CBO said Nov. 8 that full implementation of the plans would cut growth by 0.5 percentage point next year.

“The Fed is staying aggressive, the fiscal cliff worries continue and the fundamental problems in the economy haven’t let up,” Jay Mueller, who manages about $2 billion of bonds at Wells Capital Management in Milwaukee, said in a Dec. 18 telephone interview. “And until something changes yields will stay low.”

To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net


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