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Treasuries' shifting buyer base may be bond market's vulnerable point

New York

AS the US government blows through its crisis-era borrowing record, surpassing US$1 trillion a year in debt sales, it's relying on creditors who could make its deficit-financing even more costly.

America's US$15.6 trillion government-bond market - the world's largest and most liquid - isn't necessarily losing customers. But the biggest growth in demand is coming from the private sector, rather than the public side.

That matters because if these price-sensitive buyers start pushing for better rates, it could help drive up the average interest rate on the nation's debt, which is already close to a nine-year high.

The shift in the investor base is evident in auction results for 10-year Treasuries, a benchmark for global borrowing.

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The share of foreign purchases has stagnated as international reserves have peaked. But the proportion of domestic bids has risen steadily amid an explosion in exchange-traded funds and other passive-investment products. US funds bought on average about half of each monthly offering in 2018, compared with around a fifth in 2010.

"There has been an ongoing question about whether domestic buyers would be willing to absorb all the net supply or whether at some point Treasury yields would have to adjust up to a level where they became a more attractive asset," said Brad Setser, a senior fellow at the Council on Foreign Relations and a former Treasury official.

The international investor base is also evolving, away from official accounts such as reserve managers and in favour of private buyers who may be less compelled to show up at auctions if the price isn't right.

About US$6.2 trillion of Treasuries - around 40 per cent of the market - is in non-US hands, making these investors' preferences crucial for America's finances. Foreign accounts still buy large chunks of auctions, but locals have outpaced them for years.

"In essence, it's like all the increase in supply is being taken on by these investment funds, at least with respect to the auctions," said Ankit Sahni, president of Exante Data, a New York-based research firm.

Foreign official demand has stagnated in part because of a decline in global reserves, which peaked almost five years ago. The US currency's strength has also played a role.

"Particularly since the appreciation of the dollar last year, foreign official holders in emerging markets have used their reserves more actively," said Catherine Mann, global chief economist at Citigroup Inc, and former chief economist at the Organisation for Economic Cooperation and Development.

What's more, China's waning current-account surplus leaves them less to recycle into Treasuries, and sanctions may have driven sales, judging by Russia's actions last year.

Although international demand for US assets is strong among Asian institutional buyers and Europeans seeking higher returns outside the euro area, "they've tended to move to buy agencies or corporate bonds", Mr Setser said. "That's particularly true if you hedge."

To be sure, the 10-year's yield of about 2.78 per cent - more than a half-point lower than when the recession ended in 2009 - reflects strong interest, particularly against a backdrop of solid US growth.

And while the bid-to-cover ratio - a measure of auction demand - on 10-year sales has trended lower over the past decade, it's not far off its 25-year average.

Mr Sahni at Exante warned that monthly changes in Treasury auction statistics don't capture the full picture of demand. For example, participants at auctions may simply be rolling over maturing debt, or selling holdings around the same time for reasons such as portfolio rebalancing.

But these figures help inform the debate over how much a pullback in foreign or domestic participation could exacerbate forces that typically drive borrowing costs higher, such as swelling supply and a tight labour market.

The trend in demand is becoming even more relevant if the US is to avoid the worst prognoses for its finances and economy. In the previous peak for government fundraising - following the financial crisis - the economy was still recovering from recession and Federal Reserve policy was pulling borrowing costs lower.

Today's fiscal stimulus comes as those pressures are reversing, with the expansion in its 10th year and the Fed letting Treasuries run off its balance sheet. "It's uncharted territory," said Greg Staples, co-head of Americas fixed income at asset manager DWS. "This could be the first time that you've had a massive supply of Treasuries at the same time that both the Fed is either tightening or at neutral and the economy's doing pretty well."

For now, at least one potential catalyst for a buyers' strike is missing: inflation. But Mr Staples said further political dysfunction could unnerve some buyers. "At the moment, we think the market's going to accept increased supply," he said. But the partial government shutdown is only raising the stakes.

Investors' attitude towards US debt may change if the political backdrop grows more toxic as debt-ceiling and budget deadlines approach next quarter, Mr Staples said.

Treasury will get a strong signal from its buyer base in early February following the next quarterly refunding. Wall Street expects this round of borrowing to remain at historic levels. BLOOMBERG

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