A few days I ago I wrote a blog post suggesting that we need to be careful reading too much into low Treasury yields. I’d like to take a little time here to expand on my comments from that piece.
There has been a lot of talk about new historic lows in long-term US yields. We’ve clearly seen a break below the lows put in back during the financial crisis when 10yr yields approached 2% but didn’t break below. As the chart following shows, that break finally happened in 2011, and we’ve since see the market move down to near 1.50%.
The thing that doesn’t get mentioned in all the talk about rates being so low is how much of the long-term Treasury issuance the Fed is holding. The Fed went through two rounds of quantitative easing (QE) where it bought Treasury and mortgage securities. It has been running Operation Twist for the last several months whereby it sells short-term Treasuries (think T-Bills and short-term T-Notes) and buys long-term securities. That’s helped bring the yields on 10- and 30-year securities down.
It is important to keep this in mind for two reasons. The first is fairly obvious. Operation Twist is set to conclude at the end of June. That would remove a major buyer from the market, reducing demand for long-dated Treasuries. Much debate these days revolves around whether the Fed will react to recent weaker economic data to either do more Twist or to initiate QE3, or some other type of easing effort. There are folks looking for something to be announced coming out of this month’s FOMC meeting, but the comments from Fed speakers recently haven’t leaned in that direction (though certainly we could see a change of tone).
The second reason I think we need to keep all the Fed buying in mind is the size of the holdings in long-dated Treasuries the central bank has built up. It’s substantial. The numbers I’ve seen indicate the Fed currently owns about 21% of the total issuance of Treasury coupon securities (T-Notes and T-Bonds). There are fewer long-dated Treasuries outstanding, though, so as you can see from the table below, the Fed actually owns a larger fraction of those securities.
What happens when you shrink the float of a tradable security?
If you answered bigger moves and greater volatility then give yourself a prize. Why? Because when there is less of something available to trade, but volume isn’t reduced on a comparable basis, the market will move more rapidly, both up and down.
Now think about what happens when markets go into “risk-off” mode, as we’ve seen happen lately. You have a large amount of money flowing into a market which has fewer securities available to purchase. Increased demand combined with decreased availability means rapid price appreciation in those securities, and thus rapidly falling yields. That’s why one needs to be a bit cautious when viewing the recent market moves.
So where from here?
Well, it’s going to depend in part on what the Fed does. Does the central bank continue buying enough long-dated paper to maintain (or increase) its fractional holdings? Or does it stop once Operation Twist is over and hold pat with current holdings, or buy at a slower rate?
The more explosive scenario where yields are concerned is a combination of the Fed slowing or halting its purchases and the risk aversion bid coming out of Treasuries. The Treasury isn’t going to stop auctioning new debt any time soon, so we would end up with greater supply and decreased demand –both from the market and the Fed – that could send rates soaring.
Even if the Fed does keeping buying, the reduced float means we’re likely to continue to experience above volatility jumps on risk-related events for the foreseeable future. The impact of a decline in risk aversion would be a little less impactful, though, because the Fed would still be a demand factor.
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