US treasury bond yields could rise sharply in 2018, as central-bank liquidity begins to recede and heavy new supply hits the market. As global quantitative easing (QE) ebbs, foreign demand for US treasury securities could also be drying up.
The ECB will taper its purchases to €30 billion ($35.2 billion) a month from January to September 2018, and presumably zero after that, Deluard says. ECB buying would fall to $314 billion in 2018, from $832 billion this year and $1 trillion in 2016, he says.“I am convinced that the European Central Bank’s QE was eventually recycled in the US treasury market,” says Vincent Deluard, head of global macro strategy at INTL FCStone Financial. “The ECB essentially bought banks’ holdings of eurozone sovereign debt at a very nice markup, causing them to reinvest into higher-yielding US debt,” he says.
On the supply side, the US Treasury will need to roll over securities worth $3.5 trillion next year, an increase of $100 billion from this year. “Then there is also the small matter of ‘the largest tax cuts in the history of the country,’ the financing of which now seems to rest on voodoo economics,” Deluard says.
Peak QE happened in 2016, and net asset purchases by the five largest central banks should shrink by $825 billion in 2018, says Deluard. Conventional institutional investors are unlikely to pick up the slack, he adds. Defined-benefit pension plans are facing net outflows, and banks have already sold $126 billion in the second quarter of 2017.
“Putting everything together, the big-five central banks should buy a net $540 billion next year, down from $1.4 trillion in 2017 and $2 trillion in 2016,” Deluard says. The buyers of last resort, mutual funds and ETFs, may start to rotate out of bonds after five years of zero returns, he says. Flows into bond funds in the past decade have already exceeded flows into equity funds during the Internet bubble, he adds.
“There are few things more certain right now than increased treasury supply,” Shyam Rajan, head of US rates strategy at Bank of America Merrill Lynch, writes in the bank’s U.S. Rates Viewpoint newsletter. This means $800 billion to $1 trillion in excess Treasury debt in each of the next five years, as a result of Federal Reserve portfolio runoffs and the tax-cut package making its way through Congress, he says.
The US Treasury will be underfinanced by a cumulative $3 trillion to $4.5 trillion over the next five years, Rajan says. The only way to fill this projected gap would be for interest rates to rise to attract additional inflows from investors.
“Recent market moves mark the beginning of a prolonged tightening of financial conditions,” Rajan writes. “We think the market is complacent” about the effect of the downsizing of the Fed’s balance sheet.
Deluard of INTL FCStone puts it more bluntly: “With the [self-proclaimed] ‘king of debt’ as commander in chief, deficits are back; and the bond market vigilantes are sound asleep.”