With the Federal Reserve deciding to end quantitative easing (QE), Treasuries have lost a key buyer. Additionally, with the Fed pivoting away from its ultra-accommodative policy and beginning to discuss the timing of an initial rate hike, there appears to be considerable upward pressure on Treasury yields going forward. Indeed, market analysts have been predicting that without this steady demand from the Federal Reserve, Treasury yields will have to rise. But not so fast! There are several compelling reasons for Treasury rates to remain low — especially at the long end of the curve.
• Dormant inflation and sluggish global growth will delay rate hikes by the Federal Open Market Committee, the Fed’s policymaking body. FOMC members’ mere mention of raising the policy rate has Treasury rates ticking upward. Market expectations for an initial rate hike are clustered around mid-2015. With dormant inflation entrenched and sluggish growth in China, Europe and Japan, however, it seems likely the Fed will delay any hike in rates, dampening a natural source of upward pressure on Treasury rates in the process.
Recently released minutes from the FOMC’s meeting in late October bear this out. Members broadly acknowledged the risks of weak global growth on the U.S. economy. “A number of participants noted that economic growth might be slower than they currently expected if the foreign economic or financial situation deteriorated significantly,” the minutes state. Soon after the meeting, Japan released disappointing third-quarter gross domestic product data that showed the country had slipped back into recession. One surprise in the FOMC’s minutes that is subtle but worth noting was agreement that inflation that falls short of target is just as costly as runaway inflation. Look for this to be the basis of the rationale for pushing off interest rate hikes until late 2015.
• The U.S. fiscal situation continues to improve, meaning less supply of Treasuries. In fact, the federal budget deficit for the fiscal year that ended September 30 was just 2.8 percent of GDP, the lowest level since 2008. Lower deficits mean new issuance of U.S. government debt will be reduced and rates will remain soft. By noting that fourth-quarter issuance for 2014 would decline to its lowest level since 2007, Treasury officials have already confirmed a reduction in new supply. The Congressional Budget Office forecasts that the fiscal deficit will contract further in 2015.
• Despite the Fed’s ending of its bond purchase program, demand for long-dated Treasury securities continues to be strong. With the Fed stepping away as a buyer, what are the new sources of this robust demand? New capital requirements by U.S. regulators have large financial institutions buying up Treasuries to meet their liquidity requirements, an observation supported by commercial bank balance-sheet and holdings data. Additionally, with comparable rates still very low in Europe and Japan as well as the dollar enjoying a strong run, foreign investors have a growing appetite for U.S. long-term debt. Although there are no clear and timely data on foreign capital flows into Treasuries, a rough proxy supports the notion of strong demand from abroad. U.S. Treasury International Capital data for September indicate that private foreign investors increased their holdings of long-term U.S. securities by $80.5 billion. Even foreign official institutions — mostly central banks — made net purchases of $13.7 billion in September, more than double the net purchases during the previous month.
So what does this mean for Treasury yields in 2015? Investors should expect the yield curve to flatten over the next few months, with the short end of the curve rising while the long end remains fairly stable. The building expectation of an interest rate hike some time in 2015 should lend some buoyancy to short-term interest rates during this period. Investors should expect rates for T-bills, as well as for some short notes, to continue their gradual rise in advance of any FOMC rate hikes in 2015. Meanwhile, given the imbalance of supply and demand, investors should expect long-term rates to remain fairly well anchored.
Shehriyar Antia is the founder and lead strategist at Macro Insight Group, a firm that advises on macroeconomic policy, in New York. Previously, he spent a decade as an analyst at the New York Federal Reserve.
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