Meet Mr Lee and Mr Smith, the Marginal Investors in the US Treasury Market

My last blog entry sparked some interesting comments about the role of Sovereign investors in the US Treasury market. It is well known from Price Theory that market clearing prices are determined by the marginal demanders and suppliers for that good or security. But just who are these people? In most cases, they are faceless agents that come and go without recognition. In the US Treasury market, however, the marginal players have a discernible character. Meet Mr Lee and Mr Smith…

Mr Lee is an academically high achiever who has been recruited by China’s State Authority of Foreign Exchange (SAFE). He works in Beijing a team of 10 people whose job is to re-invest the coupon and maturity clip from SAFE’s USD 2.5T US Treasury portfolio. This is roughly USD 50B per month. He has a standing order with every major US Treasury market maker to buy US Treasury securities at any maturity when they get offered.

Mr Smith is an Ivy League graduate working in New York for a mid-sized hedge fund with USD 500M under management. He has been closely following the Fed and thinks the 30-year Treasury yield is simply too low. He plans to recommend selling USD 10M of 30yr UST’s in Friday morning’s strategy meeting.

Mr Lee and Mr Smith don’t know each other of course. Its Midnight on Friday in Beijing and Mr Lee hasn’t filled his weekly quota of USD 1B 30yr UST, and he just wants to go home. Fortunately, its 11AM in NYC and Mr Smith has convinced his team to sell Treasuries, so rings his prime broker and instantly his sell is matched with Mr Lee’s standing buy order. Day’s work is done for Mr Smith but Mr Lee only gets USD 10M closer to target.

Now, Mr Smith never actually owned any 30yr UST’s. He relies on his primebroker borrowing the stock. Mr Lee, on the other hand, thinks to himself “…at least I won’t have to sell that USD 10M 30yr UST, it belongs to our buy-and-hold portfolio and will roll off in 30 years.”

So the result is we have hedge funds short 30yr UST’s they never owned, while the Sovereign investor has just locked it away for 30 years. The marginal buyer is still unsatisfied while the hedgie has got his position on all too easily…

Sounds like a short squeeze is brewing and that is why interest rates in the US are heading lower.