A police officer walks in front of the Marriner S. Eccles Federal Reserve building in Washington, D.C.
The smallest budget deficit since 2008, a soaring dollar and yields on Treasuries that are higher than more than a dozen other developed nations in Europe and Asia will probably combine to bolster demand at U.S. debt auctions. That’s even after the Federal Reserve ended its bond buying in October.
“There’s global demand for high-yielding, high-quality assets and the only one that’s in the game is the U.S. bond,” Thomas Tucci, the head of Treasury trading at CIBC World Markets Corp., said in a Dec. 12 telephone interview from New York. “People continue to undervalue it.”
While the U.S. economy is poised to grow at the fastest rate in a decade and employers are adding the most jobs since 1999, the lack of inflation and concern over the
strength of growth globally is spurring the biggest returns in Treasuries since 2011. Wall Street forecasters, who cut their estimates for how much yields will rise for 11 straight months, now say there’s little chance they will reach 3 percent before the end of 2015 -- the same level where yields started this year.
At U.S. debt auctions in 2014, investors submitted bids for $6.3 trillion of interest-bearing Treasuries, or 3 times the amount sold. Since 1994, the bid-to-cover ratio this year has been exceeded only twice -- in 2011 and 2012. Before the financial crisis, the high was 2.65 times.
Deficit Spending
Record demand has helped finance U.S. government spending and deficits, enabling the economy recover from its worst contraction since the Great Depression. Since 2008, the market for U.S. debt has more than doubled to a record $12.4 trillion.Treasuries of all maturities have gained 6.1 percent this year, the most since 2011, according to index data compiled by Bloomberg. That’s pushed down yields on the 10-year note, the benchmark for trillions of dollars of securities worldwide, 0.86 percentage point to 2.17 percent as of 8:53 a.m. in London.
At the start the year, forecasters projected 10-year yields rising to 3.44 percent on expectations the Fed’s stimulus would boost the economy and allow the central bank to move toward ending its six-year-long policy of holding interest rates close to zero. Instead, lackluster U.S. wage growth, turmoil in the Middle East and Russia and the specter of deflation in Europe prompted investors to pour into Treasuries.
The auctions have taken on added importance as primary dealers, which are obligated to bid at such sales, reduced the cash they commit to facilitate transactions.
Liquidity Premium
Investors bought a record 58 percent of Treasuries at auctions this year, while dealers purchased less than any other year since the government began releasing the data in 2003. Average daily trading has fallen to 4.1 percent of the total outstanding, from 13.1 percent a decade ago, according to Fed and Treasury data compiled by Bloomberg.“It’s gotten to the point where the market depth, the liquidity that dealers can provide has been reduced, even for Treasuries,” Michael Lorizio, a senior trader at Manulife Asset Management, said by telephone from Boston on Dec. 18.
The amount of bonds sold at auction to fund U.S. spending is decreasing as faster economic growth boosts tax receipts and shrinks the deficit, which is set to narrow further in 2015.
The Congressional Budget Office estimates the shortfall will decrease to $469 billion in the year ending Sept. 30 from $483 billion last fiscal year. That would be the smallest funding gap in seven years. The deficit has declined in four of the past five years since peaking at $1.4 trillion in 2009.
Risk-Reward
“The net supply isn’t that big,” William O’Donnell, the head U.S. government bond strategist at RBS Securities Inc., said by telephone from Stamford, Connecticut, on Dec. 19.RBS, a primary dealer, estimates net supply of $625 billion in 2015, versus a projected $767 billion this year.
For J.P. Morgan Asset Management’s Priscilla Hancock, a stronger U.S. economy also means higher interest rates, which will damp investor appetite for Treasuries.
The economy will expand 3 percent in 2015 after growing 2.3 percent this year, based on the latest Bloomberg survey. Employers have added 228,000 jobs per month in 2014, the fastest pace in 15 years. While the almost 50 percent plunge in oil futures since June pushed down consumer prices in November by the most in six years, lower fuel costs will prove to be a boon for consumers and ultimately spur inflation, she said.
“That drop in the cost of oil should be stimulative,” Hancock, the global fixed-income strategist at J.P. Morgan Asset, which manages $1.5 trillion, said by telephone Dec. 18.
Shifting Expectations
“Once the Fed starts to raise rates, which we believe will be in the middle of the year, the market will bring forward its expectations,” she said.Fed Chair Janet Yellen, who downplayed oil’s influence on long-term inflation after the central bank’s policy meeting on Dec. 17, suggested a “patient” approach to rates may translate into an increase by the middle of 2015.
Traders are less certain that inflation will pick up any time soon, meaning Treasuries will probably remain in demand, according to Margaret Kerins, the Chicago-based head of fixed-income strategy at Bank of Montreal, a primary dealer.
The Fed’s preferred measure of inflation has failed to reach its 2 percent goal for 30 straight months.
Based on yields of Treasuries due in January 2016, the bond market is now warning that deflation may emerge. Investors’ outlook for cost-of-living increases, which approached 2 percent in March, has since tumbled and turned negative last week for the first time since 2009.
Currency Bonus
Foreign investors will have an “easier time buying into lower-than-expected inflation,” which preserves the value of fixed income, Kerins said by telephone on Dec. 17.Overseas demand may temper any jump in U.S. borrowing costs as the dollar strengthens and central banks in Europe and Japan step up stimulus to support their flagging economies.
The greenback, which has appreciated 13.5 percent against the yen and 12.4 percent against the euro this year, is poised to gain 4.5 percent and 3.6 percent against the respective currencies in 2015, surveys compiled by Bloomberg show. A stronger dollar boosts the value of U.S. assets for foreigners.
Yields on 10-year Treasuries are higher than notes from 17 other developed nations, including Italy, Hong Kong and the U.K. In the euro area, where inflation reached a five-year low in November, German bund yields fell to a record 0.59 percent this month and the least relative to the U.S. since 1999.
That suggests the new year may be just as bullish as 2014 was for Treasuries, Krishna Memani, the New York-based chief investment officer at OppenheimerFunds Inc., which oversees $79.1 billion of fixed-income assets, said by phone Dec. 18.
“All the things that have been helping the Treasury market will be very much in place in 2015,” he said.
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