Wednesday, September 1, 2010

Treasury Price Might Stay High But will Drop in 2011

--Treasuries are at the mercy of foreigners. But the lack of alternative investment choices constrains foreign central banks to continue buying Treasuries, yet in a slow pace.
--The slack created by central banks might be picked up by US consumers’ savings.
-- Fed has become a stronger buyer since the inception of quantitative easing. Although not permanent, the buying force might persist depending on the recovery pace. But the recent price upshot cannot be fully explained by Fed’s account.
-- GSEs have partially contributed to the price upward of Treasury since the beginning of the year. But its marginal effect might be limited.
--Liquidity is a short or mid term force and will start waning in 2011 as economy recovers gradually.
--Stock appears more attractive compared to Treasury Bonds. 10y at 2% might be a strong bottom.

Status Quo of Treasury
Treasury bond has been trading at historic high since 1962, yielding at ~2.5% as of Aug 30 2010.

Basics about Treasury
--It is used to finance budget deficit
--Broadly classified into intragovernment vs. privately held

National debt $13.3 trillion
a. intragovernment holdings 4.5 tril (34%) - Government Account (Government trust funds, revolving funds, and special funds; and Federal Financing Bank securities)
b.Social Security Trust Fund accounts for 65% of GA
( - detailed receipt vs outlay)
c. held by public/privately held 8.7 trillion (66%)

Strong buyers of Treasury of $1.4 trillion in Q1 2010
--Rest of world, $790 bill, majority buyer. It is driven by US trade deficit against the world. The US dollars held by global central banks funnel back to US in the majority form of Treasury. The driving force might decline gradually but might stay high around $500 billion for certain periods until either USD devalue or US technology improves. It implies the buying force from foreigners will decline around $100-200 bill annually.

-- Commercial banks bought $224 billion, compared to $99 billion in 2009, and less than $50 billion in previous 9 years. It has been mainly caused by consumer de-leverage. Consumers have been withholding consumption since the recession and saving rate stays and will stay high at 3%. Commercial banks used majority of the deposited money in Treasuries. The buying force from Commercial Banks might increased by $100-200 annually.

--GSE, $153 bill, $10 billion in the past nine years.
GSE has a balance sheet of $6.9 trillion including off-balance, where $3 trillion in Dec 2009 are on-balance sheet and the rest are guaranty portfolio and used to be off balance sheet.
Fannie Mae has reduced holding of Agency and GSE backed Mortgages securities to $487 in Q1 2010 from $954 billion in Q1 2009. But it started loading with Treasury $47 billion since Q1 2010 ($153 bill in Q1) because of "more liquid investments, and because we anticipate increased cash needs in 2010 to purchase delinquent loans from MBS trusts".
Another reason GSE started loading with Treasuries is because of policy mandate. Fannie Mae claimed “Our policy mandates that U.S. Treasury securities comprise an amount greater than or equal to 50% of the average of the previous three month-end balances of our cash and other investments portfolio (as adjusted in agreement with FHFA).”
I do not expect the GSEs will continue to increase buying a larger share of Treasuries as Agency and GSE Mortgages default rate started level off and liquidity pool is reasonably large enough. Fannie Mae’s Treasury portfolio was increased to $55 billion by Q2 2010.
It implies that GSE will exert only a minority force in Treasury market.
--Fed System Open Market Account (SOMA) account will continue the reinvestment in Treasuries as money tightening is not a wise option in the current economical environment. Fed owns $770 billion Treasuries and $1.1 trillion in its SOMA account. Refinanced mortgages might decrease the MBS portfolio. If Fed shift more balance from MBS to Treasury, this will exert more pricing pressure on Treasuries.

-- Flight to quality might continue to play out through the end of the year when economy improves gradually and market stabilizes.

Future Prices of Treasuries

The above analysis demonstrates that the strong driving forces might continue to persist for certain period, half to one year. But the marginally buying is limited and the Treasury yield is already close to historical low 2%, when the credit crisis culminated in 2009. But as Fed started unwind its balance sheet or risk appetite recovers materially, we would see Treasury yield start shotting up. This might happen early next year.

Stocks Seem More Attractive

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