Back in April 2013, when looking at the dynamics of global treasury supply and demand (and just before the TBAC started complaining loudly about a wholesale shortage of quality collateral), we made the simple observation that between the (pre-tapering) Fed and the BOJ, there would be a massive $660 billion shortfall in supply as just under $1 trillion in TSY issuance between the US and Japan would have to be soaked up $1.7 trillion in demand just by the two central banks.
A year later, bonds yields continue to defy conventional explanation, with ongoing demand for "high quality paper" pushing yields well below where 100% of the consensus said they would be this time of the year, and in this cycle of the so-called recovery, because for the improving economy thesis to hold, the 10Y should have been well over 3% by now. It isn't.
As a result, a cottage industry sprang up in which every semi-informed pundit and English major, voiced their opinion on what it was that was pushing yields lower, and why bids for Treasury paper refused to go away even as the S&P hit record high after record high.
And just like in April of last year, the simplest explanation is also the most accurate one. According to a revised calculation by JPM's Nikolaos Panigirtzoglou, the reason why investors simply can't get enough of Treasurys is about as simple as its gets: even with the Fed tapering its QE, which is expected to end in October, there is still much more demand than supply, $460 billion more! (And this doesn't even include the ravenous appetite of "Belgium" and the wildcard that is the Japanese Pension Fund arriving later this year, bids blazing.) This compares to JPM's October 2013 forecast that there would be $200 billion more supply than demand: a swing of more than $600 billion! One can see why everyone was flatfooted.
As Bloomberg summarizes, “Everybody was expecting supply to come down, but maybe it’s coming down sooner” than anticipated, said Sean Simko, who oversees $8 billion at SEI Investments Co. in Oaks, Pennsylvania. “There’s a shift in sentiment from the beginning of the year when everyone expected rates to move higher."
Here is JPM's math:
QE-driven demand looks set to decline as the Fed tapers. Assuming Fed tapering is completed by October, and no change in BoJ policy, bond purchases by G4 central banks should decline by $500bn vs. 2013 to around $1,080bn this year. All these components of bond demand are shown in Figure 1. The 2014 bar encompasses the projections explained above. In total, bond demand is expected to stay flat vs. last year as an improvement in private sector demand offsets Fed tapering.
How does this compare with bond supply? After peaking in 2010, government bond supply is on a declining trend due to declining government budget deficits. Spread product supply is also declining driven by European credit supply, which is contracting in both the Corporate and Agency bond space, and securitized products in the US (ABS and non-Agency MBS), which are also contracting. In these supply estimates we only included external rather than EM local debt, as the latter tends to be dominated by local EM investors. We still expect bond supply to decline by $600bn in 2014 to $1.8tr. The balance between supply and demand, i.e. excess supply, looks set to narrow from +$200bn in 2013 to -$460bn in 2014, a swing of more than $600bn (Figure 4).
Our estimates for bond supply and demand are in notional amounts rather than market values, so a gap between the two is a meaningful concept and should close via market movements. Indeed, the correlation between the estimated gap in Figure 4 and bond yield changes is 0.56, which is significant. Mechanically, the decline in the excess bond supply in 2014 vs. 2013 would imply that the yield of the Global Agg bond index should fall this year by around 40bp by simply looking at what happened before in years with similar excess bond demand to the one projected for this year, i.e. in 2008, 2011 and 2012.
The simple conclusion:
The Global Agg bond index yield has fallen by 30bp so far this year, so most of the projected decline has happened already.
Well, yeah... assuming JPM's massively downward revised estimate of global bond supply is accurate. What happens if instead of $460 billion in excess demand there is $1 trillion, or more? What is the equilibrium rate then?
And there you have it: no crazy de-unrotations, no short squeezes, no unicorn magic voodoo: simple supply and demand.
Furthermore, while we await the demographic hit to arrive sometime in 2017 which will once again send US Treasury issuance soaring as a result of a need to fund budget deficits from a welfare state caring for an aging population, the biggest wildcard until then is just what the US current account will do in the coming years. Curiously, that also happens to be Bank of America's chart of the day:
The savings gap: The US current account balance, at -1.9% of GDP, is often seen as the trade shortfall. But by definition, it is the gap between savings and investment. Simply put, if we are not saving enough to finance investment, we will need to borrow capital from abroad to fund that gap. The result: a capital account surplus or an offsetting current account deficit. With savings undershooting investment for roughly the past thirty years, the current account has been in negative territory and foreign capital inflows (netted against US outbound capital flows) have bridged that shortfall.
What is ironic here, is that if JPM is accurate in its supply/demand calculation, one of the main reasons why bond yields are tumbling has everything to do with the decling in the US trade, and thus, current account deficit. Because if the US needed more external funding, then it would be able to issue more debt, which would then result in greater supply, and higher prevailing yields. In the meantime, however, since the US government's funding needs, at least for the next 3 years that is, are lower than at any point since Lehman, one can argue that, at least based on declining supply of Treasurys (and US funding needs), the prevailing yield will drift ever lower, making life for the spinmasters (those whose livelihood depends on convincing mom and pop that sliding bond yields is not indicative of a slowing economy) a living hell for the foreseeable future.