A year ago, when Goldman published their outlook for rates in 2019, the bank projected that on top of increased issuance from Steve Mnuchin, domestic and foreign investors would need to absorb around $130 billion in Treasury supply tied to Fed runoff.
The bank also suggested that higher yields would likely be enticing for price-sensitive investors.
Fast forward 12 months, and the ground has shifted or, as Goldman puts it, “what we have observed this year differs substantially from that assessment on account of a few major changes”. Those “major changes” are:
- A sooner-than-expected end to Fed balance sheet runoff (and the subsequent decision to begin growing the balance sheet “early”)
- Lower yields
The first point above has produced a dramatically different outcome than that envisioned by Goldman (and others) this time last year. Rather than the Fed divesting some $130 billion (under the assumption that balance sheet runoff was set to continue through the end of 2019), the Fed is instead set to be a net buyer of USTs this year, to the tune of around $77 billion.
That has crowded out other investors. And speaking of other sources of demand, Goldman notes that “at current low levels… yield-seeking unlevered investors will purchase fewer” Treasurys. If you look at the breakdown of the bank’s projections for US Treasury buying, the largest shortfall can be observed in the price-sensitive asset manager category.
As for the other shortfalls illustrated in the visual, Goldman explains lower purchases from pensions by reference to falling yields which “resulted in funded ratios deteriorating slightly in 1H19… suggesting lower levels of de-risking activity”. For money market funds, it’s likely that the inversion of the curve incentivized buying at the front end, while markedly subdued (versus the bank’s projections) buying from the foreign official sector may be down to the substitution of “synthetic dollar assets created by purchasing foreign securities and hedging these holdings back to US dollars”, Goldman says.
Not surprisingly, private foreign demand is actually set to run out ahead of estimates, thanks (probably) to the allure of Treasurys in a world awash in negative-yielding debt and also due to the safe-haven appeal. On the huge overshoot from the “Household” sector, that’s probably hedge fund demand, Goldman reminds you.
So, what about next year? Well, one thing obviously sticks out from the visual: The Fed will be largest source of demand. Between the effort to reestablish an abundant reserves regime, the concurrent push to rebuild a “buffer” on top of that, MBS reinvestments and organic balance sheet growth, the Fed will likely buy more than $510 billion in USTs in 2020.
That, in turn, reduces the supply that needs to be absorbed by the public. The net supply of bills will likely be negative in 2020. “Some of this amount is likely to come out of sectors that hold a lot of bills, such as money funds and the foreign private sector, though these purchases may reduce holdings in these categories, some investors, like MMFs, may replace the loss of bills by adding short coupon securities”, Goldman writes.
The persistence of negative-yielding debt abroad will probably ensure that demand from the private sector (both domestic and foreign) will be steady, but foreign official sector buying could remain subdued thanks to “the theme of reserve diversification away from USTs”.
As a reminder, US foreign policy is encouraging de-dollarization.
“While the current US administration may be a catalyst for long-term de-dollarization, such diversification may be prudent even if Washington policies change”, JPMorgan’s Marko Kolanovic wrote last year, adding that “currency/rate diversification might be in the best interest of Emerging Market economies, time and time again left at mercy of US Federal Reserve rate cycles”.
One crucial thing to keep in mind going into the new year is that Fed purchases (and the attendant plunge in the amount of net supply available to everyone else) aren’t going to have an appreciable effect on duration. Most of the Fed buying is in bills. “While the Fed is also likely to add $189 billion in Treasury coupons to its holdings over the course of 2020, this likely won’t have much of a duration impact in our view, as the Fed is merely replacing one longer duration asset (MBS) with another (USTs)”, Goldman reminds you.
Of course, you can take all of this with a grain of salt, because as noted here at the outset, trying to project demand trends for Treasurys in the current environment is a tall order. Expect 2020 to be just as full of surprises as 2019.