After a brief decline last week, Treasury notes and bonds have rallied the past 3 days and are back near 1 year highs. Traders have commented that even new all-time highs in the S&P 500 index cannot damp demand for longer-dated Treasuries. In fact, TLT, the widely followed Treasury bond proxy, is up around 15% year-to-date, nearly doubling the return of SPY in 2014.
The Federal Reserve has been gradually winding down QE and reducing its monthly purchases since the taper began in December, but other buyers have stepped in to maintain the bid to Treasuries. However, the Fed’s overall impact should not be underestimated. The central bank’s balance sheet is now over $3 trillion, and as a result, there is an awful lot of Treasury bond supply that has been permanently taken off of the market. (Ok, not permanent, the Fed will sell its Treasuries back out onto the open market at some point in the far future.)
To get a sense for the magnitude of the Fed’s existing portfolio, see these two tweets from a government bond trader, @InterestArb:
I must sound like a broken record! After adjusting for Strips & 2 most recent auctioned bonds, Fed holds 57% of all the issuance > 5/15/30
One of the Big reasons UST Bonds have been relentless:
Fed owns $31.1B of $44.6B 69.8%
Adj for $8.5 Stripped, Fed owns 86%
In other words, the Fed owns the majority of U.S. Treasury bonds that have a maturity of 20 years or greater. (As a side note for those who want to learn more about Treasury Strips, you can start here.) That majority owner is not selling. While the Fed has pulled back on its monthly buying over the past 6 months, that has coincided with the Treasury reducing new Treasury note and bond supply as the budget deficit has declined. Here is a chart of the federal budget deficit, courtesy of Bill McBride:
Add it all up, and the persistent bid in longer-dated Treasuries has been in part due to a relatively tight supply situation in the market.
Of course, the Treasury bond market is one of the largest financial markets, so none of this is groundbreaking news. But considering this backdrop and the continued bullish price action in Treasuries, we have been reluctant to put on the bearish TLT trade discussed nearly 2 weeks ago. Even as risk appetite has been plentiful, Treasuries have shown little sign of letting up. The skewed supply/demand situation is a major factor in that state of affairs.
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