Key Investor Classes Shift to Negative Outlook on Bonds

Four investor classes, foreignrninvestors, the Federal Reserve, fixed income funds, and banks, haverndominated the U.S. Treasury (UST) market in recent years. In arnreport today Bank of America/Merrill Lynch said it sees the future demand from eachrnof the groups now turning negative for the five and ten year part ofrnthe Treasury curve, the area where these investors have been mostrnactive.</p

Foreign investors are the largestrnholders of U.S. Treasuries, with a near 50 percent share ofrnoutstanding debt holdings. In the last five years official foreignrnsources have more than doubled their holdings, from $1.5 trillion inrn2005 to nearly $4.1 trillion today. By far the largest foreignrnholders are China and Japan but other countries holding substantialrnamounts of USTs are Brazil, India, Russia and Switzerland, Theirrncombined holdings has tripled in the last five years. Portfoliorninflows into these countries, fueled by the Fed’s qualitative easing,rnhas led to sizable reserve growth which has been channeled by reservernmanagers back into USTs.</p

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The most public source of demand forrnTreasuries since 2009 has been the Federal Reserve. Since it beganrnthe first round of quantitative easing its portfolio of Treasuriesrnhas grown by nearly $1.5 trillion and the average maturities of thatrnportfolio, in part due to the 15 month life of Operation Twist, hasrnincreased from less than two years before the crisis began to tenrnyears today. </p

The impact of Fed purchases is evidentrnfrom Chart 4 which shows the sky-rocketing share of 5 to 30 year USTrndebt by the Federal Reserve while the level of privately held debtrnhas barely moved. The Fed’s mortgage-backed securities (MBS)rnportfolio has also increased by $1.25 trillion since 2009.</p

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Fixed income funds have increased theirrnTreasury holdings by $400 billion since 2009, while decreasing theirrnshare of equities. Inflows into Treasury-only funds have been small.rn Note that a sizable portion of flows into total return funds isrnlikely to have flown into Treasuries given that they make up arnsubstantial portion of the aggregate benchmark. Overall demand forrnhigh quality duration from these funds have helped keep yields andrnterm premiums at historic lows.</p

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As banks have changed the compositionrnof their balance sheets since 2008, the growth on the asset side hasrnbeen notably tilted toward growth in bank securities as compared withrnloans. Commercial banks hold $2.7 trillion in securities of whichrn$1.8 trillion is in Treasury and agency securities; agency MBSrnholdings total $1.34 trillion and Treasury and agency debt securitiesrntotal $460 trillion. This represents a portfolio growth of $500rnbillion since 2009 all in Treasury and agency securities. </p

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Under pre-Basel III guidelines bankrnregulatory capital ratios are protected from being impacted by markrnto market losses on securities and this has led to banks increasingrntheir holdings of low risk-weighted assets despite duration andrnspread risks. Declining rates and tightening spreads made a furtherrncase for owning these assets. </p

Bank of America says each of these fourrnasset classes faces a changing outlook that may lessen their demand</bfor Treasuries. For emerging market investors, higher interest ratesrnin the U.S. Have triggered large outflows and led to substantialrncurrency depreciation which in turn mean lower reserve growth andrnfewer dollars to be channeled toward Treasuries. In the case ofrncountries such as Turkey, Indonesia, and India, active interventionsrnon behalf of their currencies and the need to sell dollar reservesrnprovide a further negative for demand as Treasuries would be the mostrnliquid assets.</p