Bank Buying of Treasuries Helped Drive Yields Lower in 2014

Update: This is a follow-up on our Federal Reserve flow of funds post from Tuesday, December 9th, since data was updated on Thursday, December 11th. Please see that post, The Rest of the World Still the Dominant Treasury Investor for background.

The 2014 rally. Treasuries have persistently rallied throughout 2014 (see chart) despite:

1. Improving economic data in the US; and
2. The Fed winding down its own Treasury purchases that were part of QE, as of the end of October.

The 30yT has rallied almost 125 bp YTD from just under 4.00% to 2.75%, and the 10yT yield has dropped by 90 bp from 3.00% to 2.10%. In fact, as we head into the end of 2014 the rally has accelerated while the two lynchpins of the economy - employment and consumer spending - are showing signs of perhaps blockbuster strength.

Global demand for Treasuries remains high due to dollar strength and economic weakness outside US. We revisit the flow of funds data to see what sectors have been large marginal buyers of Treasuries this year. It is an obvious conclusion from the charts below of quarterly flows (seasonally adjusted annualized rates) that the "rest of the world" has long been the largest marginal buyer and holder of Treasuries. The "rest of the world" is a catch-all for foreign demand; in the Treasury universe it is dominated by demand from foreign central banks and other foreign official accounts.

Duration extension by foreign central banks. It is important to note that in the 2Q and 3Q of 2014, foreign buyers actually sold or ran-off nearly $300 bn in Treasury bills and bought close to $800 bn of longer-term Treasury securities, for net buying of ~$500 bn. (This breakdown is available in the complete FoF data, though we don't show it above.) That duration extension no doubt had a sizable impact on the level of rates across the curve.

US banks increase Treasury buying to satisfy regulatory requirements. The other, arguably more important trend in 2014, has been the pick-up in Treasury demand from US banks and other depository institutions. Net buying by US banks initially jumped higher in 4Q 2013 and has remained strong, rising again in 3Q 2014. This buying is the result of new regulatory rules and standards for banks - most embedded in Basel III - that have been announced and are gradually being phased-in. The most important of these are the liquidity coverage ratio and liquidity risk monitoring tools, both of which "encourage" banks to significantly increase their holdings of so-called "high quality liquid assets," of which the safest of these is Treasuries.

It has long been speculated by myself and others that, over time, the increased Treasury buying by banks due to regulatory requirements would put sustained downward pressure on rates. That has clearly materialized in 2014. I don't know how close banks are to satisfying the new liquidity requirements, though there are several groups that track and estimate such measures (The Clearing House and the BIS are two such organizations). I will try to find estimates from them and post later this week.

A flat scenario for 2015? One takeaway here is that, at least on the part of banks, the outright level of Treasuries that they hold has been increased dramatically over the past year - from $276 bn to $442 bn - (see chart above) and this will be sustained. Once banks reach the appropriate liquidity thresholds, the growth in the level and flows is likely to moderate, but as securities mature they will need to be replaced, so the overall net flows from banks will probably be positive going forward, keeping some overall pressure on Treasury yields.

Foreign buying of Treasuries over the longer-term is no doubt the biggest swing factor. Although foreign official accounts are generally buy and hold, any pull back in Treasury buying on the margins - due to either a strengthening global economy or diversification away from US dollar assets - will be felt in Treasury yields. Although it's possible that there could be a moderation of foreign and bank demand in 2015, we suspect it will persist at least for the next two to three quarters.

Would the Fed invert the curve? In our minds (ok, my mind) that leaves the following open question: what if the 10yT yield hits a ceiling at ~2.50% as the Fed begins to raise rates in 2015? Does that effectively cap the path of short term interest rates for this cycle given that it may stop the Fed from deliberately inverting the yield curve? Is it possible that the path of short term rates rises from 0.25% to 2.00% and stops there? I suppose that really depends upon what happens with inflation in the US and globally, but it seems to be getting more and more difficult to project inflation to rise substantially in the near term.


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