By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) – The Federal Reserve’s gradual withdrawal from the U.S. Treasury market as the coronavirus pandemic eases and liquidity improves could dry up appetite for longer-dated government debt and push up long-term interest rates months from now.
The Fed has purchased about $1.3 trillion in Treasuries since an emergency plan kicked off last month to address liquidity issues in the $17 trillion market.
For now, there is no indication that Treasuries have become less popular, with most auctions of U.S. debt being oversubscribed. In an era of negative yields, benchmark 10-year yields between 0.5% and 0.8% still stand out, analysts said.
But the Fed is slowly reducing its purchases, to an average of $15 billion per day last week from a peak of $75 billion per day from March 19 to April 1. Analysts are growing worried there may not be enough demand for Treasuries if the Fed is pulling back.
“If they do withdraw support, it will be the long end that will be under pressure,” said Priya Misra, head of U.S. rates strategy at TD Securities. “People are not getting paid to take on duration risk.”
Yields on U.S. 10-year notes and 30-year bonds were last at 0.589% and 1.163%, respectively.
U.S. Treasury yields raced higher in 2013, an episode in financial markets referred to as a “Taper Tantrum” as the Fed signaled it wanted to slow the pace of asset purchases. The Fed was only able to start shrinking its balance sheet in 2017, nine years after it began expanding it during the global financial crisis.
Treasury has so far issued more than $1 trillion in bills and other types of short-term debt to finance the government’s roughly $3 trillion stimulus package in response to the pandemic’s economic devastation. It has focused on the front end of the curve where there is ample demand from investors fleeing risky assets or trying to raise cash as a liquidity buffer.
But with interest rates at record lows, analysts said it would make sense for the U.S. government, at some point, to issue debt with longer maturities.
“We have about $1 trillion coming from bills to fund the stimulus, but that’s not enough,” said TD’s Misra. “The stimulus is nearly $3 trillion so the rest of that will have to come out from coupons out the curve, including a new 20-year. I think that’s where the Fed support will become important.”
Treasury announced in January that it plans to issue new 20-year bonds.
Investors are operating on the assumption that the Fed will step in any time and increase their purchases again, analysts said.
“It would be difficult for the Fed to withdraw from the Treasury market,” said Vincent Deluard, global market strategist at INTL FCStone in San Francisco. “In Europe, there are emergency measures that last for 10 years. The funding aspect would be very problematic.”
When the health crisis improves, even if that is before the arrival of treatments or a vaccine, the Fed may be constrained to intervene in the market again, especially with a balance sheet that has ballooned to $6.6 trillion, or about 31% of expected U.S. gross domestic product for 2020.
“I would be careful with longer-dated bonds until I see there are others, other than the Fed willing to buy the increased issuance that the Treasury is putting out there,” said Patrick Leary, chief market strategist and senior trader at Incapital in Chicago.
Front-end Treasuries are typically supported by real money accounts such as state and local governments, asset management firms, trust companies and banks.
On the long end of the curve, 10-year notes and 30-year bonds tend to attract speculative and fast money accounts such as hedge funds, analysts said. Insurance companies, pension funds and central banks are also buyers of long-dated debt, but analysts wondered whether these investors would support the Treasury market if the Fed is no longer buying.
“Ultimately, it’s about future price appreciation. No one’s buying 30-year Treasuries right now for its 1.16% yield,” said Leary.
“They’re buying for safety or for future price appreciation or total return,” he said. “In order to get that, they need to sell it to somebody at a higher price and the biggest buyer (the Fed) just decided to step back.”