Nobody Mourns Death of QE as Treasuries Prove Insatiable

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Customers shop at a Costco Wholesale Corp. store in Louisville, Kentucky, U.S. Weekly earnings for full-time employees are still lower than in the period just before the recession and the buying power of workers’ paychecks is no higher than it was in 1999. Photographer: Luke Sharrett/Bloomberg

Even with the end of unprecedented bond purchases from the Federal Reserve, demand for U.S. Treasuries looks as strong as ever.

Investors submitted bids for $5.54 trillion of government debt at auctions this year, or 3 times the amount sold, data compiled by Bloomberg show. The bid-to-cover ratio is higher than the 2.87 last year, when the Fed purchased more Treasuries than at any time since the central bank began quantitative easing in 2008, and has been exceeded only twice on record.

While the Fed has been the biggest source of demand since the financial crisis, the willingness of foreign central banks, insurers and pensions to pick up the slack as it wound down its third and most aggressive round of stimulus suggests there’s plenty of buyers to keep U.S. borrowing costs low. Yields on the 10-year note, the benchmark for trillions of dollars of debt securities, have fallen about 0.7 percentage point to 2.33 percent since the Fed started tapering in January.

“There may not be enough Treasuries to go around,” William O’Donnell, the head U.S. government bond strategist at RBS Securities Inc., one of the 22 primary dealers obligated to bid at Treasury auctions, said in a Oct. 27 telephone interview from Stamford, Connecticut. “We watched the Fed slow its purchases and yet rates are still falling.”

QE Legacy

The Fed ended its latest round of quantitative easing, commonly known as QE, in October after amassing $790 billion of Treasuries and $813 billion of mortgage-backed bonds through monthly purchases that began in January 2013.

The program, which the Fed started in December 2008, was intended to restore demand and lower borrowing costs after the credit crisis by inundating the U.S. economy with cheap cash. In all, the central bank added $3.96 trillion of bonds through QE and more than quadrupled its assets from less than $1 trillion since the stimulus measures were first announced.

With the Fed winding down its buying this year, most Wall Street prognosticators anticipated Treasuries would slump, pushing up their yields. That hasn’t happened as buyers such as foreign central banks and pension funds stepped up their own purchases. Treasuries have returned an average of 4.9 percent this year, index data compiled by Bloomberg show.

Demand at U.S. Treasury auctions, where $1.85 trillion of interest-bearing government bonds have been sold, is on pace to be the third highest in data compiled by Bloomberg going back to 1992 and compares with the record 3.15 times in 2012.

Auction Demand

Before the financial crisis, the bid-to-cover ratio never topped 2.65. The proportion of purchases from investors, rather than bond dealers, has also increased to 58 percent, the highest level since at least 2003.

Foreign investors added more Treasuries in August than any time this year and now hold a record $6.07 trillion of the debt, the most recent data from the Treasury Department showed.

Investors have poured into Treasuries even as yields hover close to historical lows. Yields on the 10-year note, which plummeted below 2 percent last month, averaged close to 5 percent in the decade prior to the financial crisis.

One of the biggest reasons why U.S. government bonds may remain in demand, even as the economy gains momentum, is because lackluster wage growth has constrained household spending and any resultant pressure on consumer prices that would erode the value of fixed income payments.

Living Expenses

“We are seeing continued low yield levels despite tapering because we still have no inflation pressure,” Jeffrey Klingelhofer, a money manager at Thornburg Investment Management Inc., which oversees $89 billion, said by telephone from Santa Fe, New Mexico, on Oct. 29.

Weekly earnings for full-time employees are still lower than in the period just before the recession and the buying power of workers’ paychecks is no higher than it was in 1999.

Last week, a government report showed consumer spending unexpectedly decreased 0.2 percent in September, more than any economist projected in a Bloomberg survey. Weak consumer demand has held inflation, based on the Fed’s preferred measure, below its 2 percent target for 29 straight months. The reading slowed to 1.4 percent in September, the least since April.

Bond yields suggest little pickup in the cost of living before the end of the decade, with traders anticipating that prices will rise an average 1.57 percent annually over that span. As recently as June, they were pricing in annual inflation of 2.1 percent over the next five years.

Coin Flip

The lack of inflation also indicates the Fed can take its time before it starts boosting interest rates, which the central bank has kept close to zero since 2008.

The odds of a rate increase in September 2015 is currently little more than a coin flip, with most wagers skewed toward the last three months of next year, data compiled by Bloomberg show. At the start of September, futures trading indicated the Fed would probably lift rates by July.

Bulls in the $12.3 trillion market for Treasuries who have pushed down yields may be unprepared for how strong the U.S. is growing, according to Gareth Isaac, a London-based fixed-income manager at Schroders Plc, which oversees $646 billion.

Even as Europe and Japan show signs of weakness, the world’s largest economy expanded at a 3.5 percent annual rate last quarter, capping the strongest six months of growth in most than a decade.

“The market is too complacent,” Isaac said in an Oct. 28 interview. “The growth in the U.S. we’ve seen in the face of a slowing global environment has been remarkable, and U.S. yields so low aren’t reflecting it.”

Yield Forecasts

Based on a “fair value” model developed by Goldman Sachs Group Inc., Treasuries may be overvalued relative to the outlooks for growth and inflation. Using the model, the New York-based firm estimates a “fair value” yield of 2.88 percent for the 10-year note at the end of this year. That compares with its year-end forecast of 2.5 percent.

Some investors have started to take notice. While demand at U.S. debt auctions reached some of the highest levels since the government began releasing the data in 1993, the Treasury Department’s $93 billion sale of shorter-term notes last week attracted the fewest bids since July 2009.

Economists and strategists, who erred on the direction of yields this year, now predict those on the 10-year note will rise through next year and end at 3.38 percent, a full percentage point higher than current levels.

Global Demand

Barbara Cummings, the director of fixed income at Boston Private Wealth Management, which oversees $9.2 billion, doesn’t see demand letting up any time soon.

Weaker global demand and geopolitical turmoil from Russia to the Middle East will lure buyers to the world’s deepest and most liquid bond market, while QE in Europe and Japan has made U.S. yields more attractive on a relative basis.

Yields on 10-year Treasuries are almost 1.5 percentage points higher than comparable German bunds, approaching the widest gap since 1999, data compiled by Bloomberg show.

“Demand has picked up so much globally that it will diminish the effects of the Fed concluding their purchases,” Cummings, said by telephone on Oct. 29. “If you look at government bond yields around the world, the U.S. is one of the higher yielding and certainly the highest quality.”

The supply of new U.S. government bonds will also be constrained because the Fed plans to maintain the record level of its holdings until raising rates by re-investing proceeds from maturing debt. The Fed owns $867 billion of Treasuries due in 10 years or more, equal to almost half the $1.46 trillion outstanding, data compiled by Bloomberg show. In 2008, the central bank held just 18 percent of the debt.

“The Fed is a very, very important investor still,” Christian Schulz, a senior European economist at Berenberg Bank in London, said by telephone Oct. 30.

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