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Who is going to buy all of these Treasuries? Bond investors have never dealt with an influx of Treasury bonds quite like what has been issued in the last year. The combinations of the TARP, federal stimulus initiatives, and falling tax revenues have resulted in record borrowing. In the 12-months ending August 31, the Treasury has issued over $2 trillion in new bonds and bills. Putting aside questions of public policy, there is a very real question of who is going to buy all of these bonds? The reality is that the Treasury has had very little trouble selling all those Treasury bonds. During September 2008, the month that Lehman Brothers and AIG failed, the 10-year Treasury ranged between 3.39% and 3.86%. Today, despite $2 trillion in new Treasuries outstanding, the 10-year yields 3.30% - a higher price today than a year ago. It is a simple fact of economics that if the price of a good is higher in the face of higher supply, demand must also be stronger. This might initially seem paradoxical until one considers the broad bond market, beyond just Treasury bonds. The chart below shows annualized growth in various bond market sectors from 1998-2008 in solid bars and year-to date 2009 through second quarter in the shaded bars.
The chart shows that while Treasury issuance is well ahead of the recent pace, (13.9% in 2009 vs. 7.0% over the previous 10-years) the overall bond market has only increased by 2.5% in 2009. In fact, excluding Treasuries, the overall size of the bond market has decreased slightly in 2009. Another consideration is the competition for Treasury bonds. In terms of safety and liquidity, Agency mortgage-backed securities, Federal Agencies, and money market securities are most comparable to Treasury bonds. As the chart above shows, all three have contracted during 2009. Combined, these three sectors have decreased by $686 billion in total outstanding so far this year. Debt levels are also declining away from the bond market. According to the Federal Reserve, household debt overall has declined by 1.2% in the last 12-months, the first outright decline in consumer debt in the history of the series. Total business debt has declined so far in 2009, which would only be the third yearly decline in the last 30 years. Whether loans are made in the public bond market or at banks, it still is competition for loanable funds. Therefore declining debt levels overall are supportive of low interest rates. Not only is the bond supply picture more favorable than it might seem, but demand is coming from new places as well. The graph below shows the amount of Treasury purchases by investor type from 1985 to present.
Of course, all investor types have been buying more Treasuries because there are more Treasuries to buy. The next chart shows buying as a percentage of issuance. It compares the average from 1998-2008 with the current mix of Treasury buying.
Looking at the percentage chart above in consort with the purchase amount chart above, we see that while foreign buying has increased in absolute terms, its decreased substantially as a percentage of all Treasury purchases. The big increase in percentage terms has been households, which had been net sellers during most of the last decade, are now the second largest source of Treasury demand. So what’s changed that has households pouring into U.S. debt? Savings. According to the Bureau of Economic Advisors, consumers only saved $145 billion of their income in 1Q 2008. In 2Q 2009, consumers saved $545 billion.
The money consumers are saving is going into bonds. Consider mutual fund flows. Investors have poured over $250 billion into bond mutual funds so far in 2009, nearly double the last two years combined. Meanwhile the net inflow into equity mutual funds has been virtually zero.
It is important to remember that interest rates are merely the price of borrowed money. Like any price, interest rates are determined by supply and demand. Right now interest rates are low because the overall supply of bonds is relatively low and demand for bonds is unusually high. Therefore any bet that interest rates will rise hinges on one of these two conditions changing. There are three obvious candidates. One is that households could decrease their savings rate. While this is possible, many consumers are currently mired in debt. While bankruptcies and foreclosures grab the headlines, most of these consumers will just increase their savings rate and eventually work down their debt levels. While this is healthy for our economy long-term, it will result in less spending and more savings for several years to come. Another is that investors could begin to rotate out of bonds and into riskier assets, such as stocks. It has long been shown that mutual fund flows are actually a lagging indicator, that is to say that mutual fund investors tend to invest heavily in an asset class just as its peaking and sell heavily just as its bottoming. The last is that business demand for credit could rebound. Overall business borrowing has declined so far in 2009, only the third annual decline in the last 35 years. However, as the economy recovers, businesses will again desire to expand capacity. Some of this will be accomplished through bond issues and/or bank loans, effectively increasing the supply of credit. So the eventual catalyst for higher interest rates probably does not have anything to do with Treasury issuance. It probably has more to do with increasing confidence on the part of individual investors and businesses. |
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