US Treasuries sell-off gathering pace

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But while things may be hunky-dory for the Fed in terms of the stock market and improving economic statistics, the bond market is the fly-in-the-ointment. “Is the bond market’s Arab Spring upon us?” Business Insider asks, following another torrid day for US Treasuries yesterday. The yield on 10 year Treasuries stood at 2.04% at the start of trading on Monday; by the close of play yesterday, it had had risen to 2.27%. The yield on the 30-year bond settled at 3.41% – up from around 3.17% on Monday.

These are of course still paltry yields in the context of decadal averages in these assets, and many financial commentators have got burned in recent years predicting blood in the bond market. While all common sense and rationality tells us that yields on Treasuries must rise given the deteriorating state of US public finances, yields remain very depressed by historical standards – as can be seen from the chart below that tracks the 10-year yield back to 1963.

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The old adage “the market can remain irrational longer than you can remain solvent” has applied very well to the Treasury market in recent years – with the bulls helped of course by the Fed’s drastic open market operations since 2008. The Fed now owns more than 40% of the maturing Treasuries for certain years.

This market bears close attention. Are the bond vigilantes at last making an appearance?

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What has happened is very simple - the happy talk about the US economy coming out of the FOMC minutes has traders jettisoning safe haven trades and even short term Treasuries in favor of the bull train leaving the station in the US equity markets. The problem? The last thing that the Fed and the US government needs or wants is a rising interest rate environment.
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The Fed has basically undercut it own low interest rate policy by giving investors the greenlight to sell bonds in order to deploy those funds into the equity markets. See what happens when you engineer a stock market rally?

I suspect that the Fed is going to be getting increasingly nervous if this sell off in the bonds, particularly the long end, continues unabated. Let's see how far the bond bears will push them.
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... Spreadbury's alternative scenarios outline the possibility for QE to stop next year, which would send rates to 3 percent, but he said the negative impact on the economy would be so great that such a scenario was not very likely.

Ian Winship, absolute return bond fund manager at BlackRock, said while he thinks yields on the 10-year Treasury will rise, he said the Fed will prevent them rising over 3 percent, as anything over that could "short circuit" the recovery.

"For those that think yields are going a lot higher– that's a big call. If they don't control the yield then that tapers growth more than anything else, and when inflation is barely above 1 percent, that is a real worry for the Fed," said Winship.

"If they go to 3 percent, that is going to increase the mortgage rate and take away one of the pillars that is supporting the U.S. economic revival."

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... now that the Fed has refused to taper, it is absorbing over 0.3% of all Ten Year Equivalents, also known as "High Quality Collateral", from the private sector every week. The total number as per the most recent weekly update is now a whopping 33.18%, up from 32.85% the week before. Or, said otherwise, the Fed now owns a third of the entire US bond market.

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At this pace, assuming Janet Yellen keeps delaying the taper again and again over fears of how "tighter" financial conditions would get, even as gross US bond issuance declines in line with the decline in deficit funding needs, the Fed will own just shy of half the entire bond market on December 31, 2014... and all of it some time in 2018.

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In summary: someone, unclear who, operating through Belgium and most likely the Euroclear service (possible but unconfirmed), has added a record $141 billion in Treasurys since December, or the month in which Bernanke announced the start of the Taper, bringing the host's total to an unprecedented $341 billion!

Also of note: Chinese holdings of US Paper dropped by $2.7 billion to $1273 billion, offset by Japan's $9 billlion increase in holdings to $1210 billion, as the convergence between the two countries resumes.

One thing that is certain: the mystery buyer is not Russia, which in February, or just as the Ukraine conflict was starting, sold another $6 billion, bringing the Russian total to $126 billion, the lowest since 2011, and the biggest annual drop, -24%, in holdings in history.

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