A New Dynamic in the US Treasury Market?

Casual empiricism is a dangerous pursuit, especially if the commentator extrapolates a few recent observations into general trends. However, sometimes there is no other way to make to detect new market behaviour. So at the risk of overinterpreting a few datapoints, here is my take on what is happening in the US Treasury market this last few weeks…

First, some facts. US Treasury markets experienced their most severe sell off since 1994 during the last two weeks of March. Both 10yr and 30yr bond yields rose 40bp during this period implying a loss of roughly 2.8% and 6.4% on each maturity respectively. The trigger for the sell off came from indications that the Federal Reserve did not intend to implement additional quantitative easing, that is, the Fed had stopped plans for further purchases of long maturity bonds.

Now, let us reflect on QE a bit. When it was first announced in 2009, the bond market rallied a bit but then sold off. The argument at the time was that QE would be inflationary and hence bad for long maturity nominal bonds. So why doesn’t the reverse logic apply in 2012 – that is, less QE is good for bonds?

My casual empiricism suggests that there is an opinion split between the US and Asia on this question. During the last few weeks, it appears that Treasuries tend to sell off in the US, only to rally back during the Asian trading session. The short term traders in the US time zone are drawn to sell longer maturities ostensibly anticipating tighter monetary policy, while the longer term foreign reserve managers in Asia see the higher yields as attractive in real terms due to the Fed’s inflation credibility. This US v Asia market dynamic is quite new…

So who will win? 20 years ago the weight of money would have favoured the US. Today, however, the majority of Treasuries are owned by the big Asian reserves managers (Japan and China own 43% between them alone). The weight of money argument now favours Asia so expect a rally in bonds and correspondingly lower US Treasury yields going forward.