Key Investor Classes Shift to Negative Outlook on Bonds

Four investor classes, foreign
investors, the Federal Reserve, fixed income funds, and banks, have
dominated the U.S. Treasury (UST) market in recent years. In a
report today Bank of America/Merrill Lynch said it sees the future demand from each
of the groups now turning negative for the five and ten year part of
the Treasury curve, the area where these investors have been most

Foreign investors are the largest
holders of U.S. Treasuries, with a near 50 percent share of
outstanding debt holdings. In the last five years official foreign
sources have more than doubled their holdings, from $1.5 trillion in
2005 to nearly $4.1 trillion today. By far the largest foreign
holders are China and Japan but other countries holding substantial
amounts of USTs are Brazil, India, Russia and Switzerland, Their
combined holdings has tripled in the last five years. Portfolio
inflows into these countries, fueled by the Fed’s qualitative easing,
has led to sizable reserve growth which has been channeled by reserve
managers back into USTs.

The most public source of demand for
Treasuries since 2009 has been the Federal Reserve. Since it began
the first round of quantitative easing its portfolio of Treasuries
has grown by nearly $1.5 trillion and the average maturities of that
portfolio, in part due to the 15 month life of Operation Twist, has
increased from less than two years before the crisis began to ten
years today.

The impact of Fed purchases is evident
from Chart 4 which shows the sky-rocketing share of 5 to 30 year UST
debt by the Federal Reserve while the level of privately held debt
has barely moved. The Fed’s mortgage-backed securities (MBS)
portfolio has also increased by $1.25 trillion since 2009.


Fixed income funds have increased their
Treasury holdings by $400 billion since 2009, while decreasing their
share of equities. Inflows into Treasury-only funds have been small.
Note that a sizable portion of flows into total return funds is
likely to have flown into Treasuries given that they make up a
substantial portion of the aggregate benchmark. Overall demand for
high quality duration from these funds have helped keep yields and
term premiums at historic lows.



As banks have changed the composition
of their balance sheets since 2008, the growth on the asset side has
been notably tilted toward growth in bank securities as compared with
loans. Commercial banks hold $2.7 trillion in securities of which
$1.8 trillion is in Treasury and agency securities; agency MBS
total $1.34 trillion and Treasury and agency debt securities
total $460 trillion. This represents a portfolio growth of $500
billion since 2009 all in Treasury and agency securities.



Under pre-Basel III guidelines bank
regulatory capital ratios are protected from being impacted by mark
to market losses on securities and this has led to banks increasing
their holdings of low risk-weighted assets despite duration and
spread risks. Declining rates and tightening spreads made a further
case for owning these assets.

Bank of America says each of these four
asset classes faces a changing outlook that may lessen their demand
for Treasuries. For emerging market investors, higher interest rates
in the U.S. Have triggered large outflows and led to substantial
currency depreciation which in turn mean lower reserve growth and
fewer dollars to be channeled toward Treasuries. In the case of
countries such as Turkey, Indonesia, and India, active interventions
on behalf of their currencies and the need to sell dollar reserves
provide a further negative for demand as Treasuries would be the most
liquid assets.


A stronger dollar and weakening safe
have status of both JPY and CHF is likely to mean lesser intervention
in these countries going forward. Interventions in Japan in 2010 and
2011 totaled $210 billion, much of which was channeled into USTs.

While the timing is still uncertain it
is obvious that the Federal Reserve is nearing the end of its asset
purchase program
and will no longer be a large buyer of duration.
This means the private market will have to absorb a substantial part
of the duration supply. Given the durations around which the
quantitative easing programs were centered the point of maximum
impact of increased private duration is likely to be in the 5 to 10
year part of the curve.

Possibly because of the weakness in
fixed income performance in May, fixed income fund flows reversed in
June and July to nearly $25 billion in outflows. The initial flow
from fixed income into cash was not concerning as such moves are
temporary but recent flows into equity funds are a concern. Equity
funds have received nearly $40 billion over the last five weeks and
further inflows into risky assets is likely to mean the start of a
longer term trend.

The three largest U.S. Banks by assets
reported a combined $10 billion loss in the second quarter almost
entirely due to the rise in rates and spreads. Changing Basel II
rules mean large banks have to include unrealized gains and losses on
their AFS portfolios when calculating regulatory capital. Thus
another bad quarter would be even worse under the new rules, not only
hurting shareholder equity but also Tier 1 capital and leverage
rations. In addition, the recovering economy could mean an increase
in loan demand and thus a reluctance for banks to tie up assets in
longer-term low-yielding fixed income assets

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