Hoarding Treasuries Helps Dealers as Europe Woes Rise
Wall Street’s biggest bond firms are buying the most Treasuries in two years, driving the biggest rally in government bonds since 1995, as Europe’s sovereign-debt crisis worsens.
Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of the 18 primary dealers of U.S. securities that trade with the Federal Reserve shifted from a $23.2 billion bet against Treasuries to holding $37.1 billion of the debt as of May 26, central bank data show. At the same time, their non-Treasury holdings of fixed-income assets fell 17 percent to $211 billion as they cut higher-risk securities such as corporate bonds.
The combination of growing concern about potential defaults in Europe and the lowest inflation rate in four decades is boosting demand for U.S. fixed-income assets. While bond dealers predicted in December that yields would rise for a second consecutive year, Treasuries have returned 4.55 percent, including reinvested interest, the most at this point since 1995, Bank of American Merrill Lynch indexes show.
“Time for a mea culpa,” bond strategists at Barclays Plc led by Managing Director Ajay Rajadhyaksha in New York, wrote in a research report dated June 4 as the primary dealer cut its forecast for 10-year note yields to 3.85 percent from 4.3 percent. Government debt has “been helped by heightened risk aversion, driven mainly by Europe, almost since the start of the quarter,” they wrote.
The strategists said May’s employment report also “raised new questions” about the strength of the U.S. economic recovery. The Labor Department said June 4 that private payrolls rose by 41,000 last month, trailing the 180,000 median forecast of 35 economists surveyed by Bloomberg News.
“The lesson we’ve learned is small sources of risk can get amplified,” said Amitabh Arora, head interest-rate strategist at New York-based primary dealer Citigroup Inc. Bond firms usually hold a so-called short position in Treasuries to hedge against swings in the value of higher-yielding assets, he said. The Fed doesn’t disclose the holdings of individual dealers.
Citigroup forecast in December that 10-year note yields would climb to 4.45 percent by year-end. They closed last week at 3.20 percent, after dropping 0.37 percentage point in May, the biggest monthly decline since tumbling 0.7 percentage point when credit markets froze in December 2008.
The yield was little changed at 3.20 percent as of 9:24 a.m. in New York.
The median estimate in a Bloomberg News survey in December survey of primary dealers was for yields to rise this year to 4.14 percent from 3.84 percent at the end of 2009. Investors would barely break even once coupon payments are taken into consideration if yields were to rise to that level, according to data compiled by Bloomberg. The median estimate in a May survey of 81 respondents for year-end is 4.04 percent.
Bonds are also gaining as inflation, which erodes the value of bonds over time, slows. The consumer price index dropped 0.1 percent in April, the first decrease since March 2009, figures from the Labor Department showed May 19. Excluding food and fuel, the so-called core rate was unchanged, capping the smallest 12-month gain in four decades.
“There’s more of a fear of deflation than inflation at the moment,” said Jason Brady, a managing director who helps oversee $4 billion in fixed-income at Thornburg Investment Management in Santa Fe, New Mexico.
While bonds have rallied, the amount of total marketable U.S. debt outstanding has risen to $7.96 trillion from $4.4 trillion in mid-2007 as the Obama administration finances a rising budget deficit and fiscal spending to spur the economy.
“The world is full of dirty shirts in terms of excessive debt, and the United States is one of those countries, but it still remains the reserve currency and still remains the flight to quality haven,” said Bill Gross, manager of the world’s biggest bond fund as co-chief investment officer at Newport Beach, California-based Pacific Investment Management Co. “The U.S. is the least dirty shirt,” he said during a June 4 radio interview on Bloomberg Surveillance with Tom Keene.
Dealers’ balance sheets have been positioned to gain from long-term Treasuries in three periods since 1997, when they began reporting their holdings to the Fed.
The first was from October 1998 through December 1998 following the collapse of hedge fund Long-Term Capital Management LP. Treasuries gained 5.6 percent in the second half of 1998 as dealer bets in favor of Treasuries rose to $15.7 billion, Bank of America Merrill Lynch indexes show.
Their holdings rose in February through June of 2009, as the global financial crisis worsened and the Standard & Poor’s 500 Index fell to a 12-year low. Treasuries returned 6.2 percent from Sept. 12, 2008, when dealers had a $78 billion short position, through April 10, 2009, when their bet in favor of bonds peaked at $37.4 billion.
Bond firms began building a net long position again in March as Europe’s fiscal crisis worsened. The European Union and International Monetary Fund unveiled an almost $1 trillion loan package last month to halt the slide in the euro and local bonds after Greece’s budget deficit rose to almost 14 percent of gross domestic product, exceeding the EU’s 3 percent limit.
Since Feb. 19, when dealers had an $8.2 billion bet against Treasuries, U.S. government debt has gained 2.7 percent. They now hold $27.9 billion of the securities.
Investors have pushed the dollar up 27 percent versus the euro since November as bond yields in Greece, Portugal and Spain rose along with concern about their budget deficits. Last week, the European Central Bank estimated that the region’s lenders will have to write off 195 billion euros ($237 billion) of bad debts by 2011.
Spain has lost its AAA grade at Fitch Ratings as the nation struggles to cut the region’s third-largest budget deficit as a percentage of GDP. Hungary’s economy is in a “very grave situation,” and talk of a default isn’t “an exaggeration,” Peter Szijjarto, a spokesman for Prime Minister Viktor Orban, said June 4 in Budapest. Hungarian State Secretary Mihaly Varga said June 5 that the comments were “unfortunate” and “exaggerated.”
Dealers’ buildup of Treasuries “does indicate to you how still very fragile the system is,” John Fath, a principal at investment firm BTG Pactual in New York and the former head Treasury trader at primary dealer UBS AG, said last week in a telephone interview. “When you have headlines like that popping out, it doesn’t instill a lot of confidence about what’s happening over there.”
The euro’s decline to $1.1967 at the end of last week is increasing demand for dollar assets “and may be driving some of those larger dealer positions,” said Brady at Thornburg Investment Management. The currency fell to as low as $1.1877 today, the weakest level since March 2006, before trading little changed at $1.1972.
Global purchases of U.S. equities, notes and bonds totaled a net $140.5 billion in March, compared with $47.1 billion in February, the Treasury Department said May 17.
Dealers are also loading up on Treasuries to take advantage of the near-record gap between yields on the securities and the Fed’s target interest rate for overnight loans between banks, now at a range of zero to 0.25 percent. Commercial lenders’ holdings of Treasuries and debt of government-chartered companies such as Fannie Mae and Freddie Mac rose in each of the past six months through April, an increase of $112.5 billion to $1.5 trillion, Fed data show.
“That’s about as risk free a trade as you’re going to get,” said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, which oversees $22 billion.
The shift into Treasuries also reflects a slowdown in corporate sales. Companies issued $458 billion of bonds through May, $159 billion less than in the same period last year, according to Bloomberg data. The Treasury sold $1 trillion of notes and bonds during the same time, an increase of $209 billion.
Bidding has increased to record levels on 10-year note auctions this year. The five sales received $3.16 in bids for every dollar of 10-year debt sold, compared with $2.63 in 2009, the highest average since at least 1994, the first full year after the Treasury began releasing the data.
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