Could U.S. Treasuries Climb When The Fed Stops Buying Them?

  • Yields have declined each time after QE programs were halted
  • Balance sheet reduction is tightening, so curves to flatten

When the biggest single holder of Treasuries starts cutting its holdings, it may be one of the best times for investors to buy more of them, according to Chris Wood, a strategist at CLSA Ltd. in Hong Kong.

The recent selloff in bonds has spurred speculation that yields could rise further if the Federal Reserve goes through with plans to start trimming its balance sheet this year by reinvesting less than the full amount it receives from maturing debt. However, because such a reduction would represent policy tightening, it would flatten the yield curve and bring down 10-year yields, according to Wood. He points out similar dynamics in the Fed’s three bouts of quantitative easing over the past decade.

“Just as the yield curve has flattened in response to two Fed rate hikes this year, so should the same reaction follow in the case of balance sheet contraction,” Wood wrote in a July 13 report. “It should be remembered that on those occasions when the Fed stopped or slowed quanto easing in the post-2008 era, the bond market rallied even though the Fed was buying fewer bonds.”

That puts Wood at odds with commentators including JPMorgan Chase & Co. Chairman Jamie Dimon, who said Tuesday the unwinding of central bank bond-buying programs is an unprecedented challenge that may be more disruptive than people think. Treasuries have rebounded after suffering their worst two-week slump since March, a selloff that accelerated after European Central Bank President Mario Draghi signaled he may be open to reducing asset purchases.

The key risk that CLSA’s Wood sees for bonds has very little to do with central banks. He’s more interested in the fate of President Donald Trump’s fiscally stimulative plans for tax cuts and infrastructure spending. The loss of momentum for what some have called Trumponomics does a lot to explain the bullishness for 10-year Treasuries among large speculators, he said.

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