Back in May 2013, when we wrote "How "Modern Money" Really Works" and noted that in the current environment, as a result of prudential regulation, derivative clearing requirements, bilateral margin requirements and general economic uncertainty including deflationary scares and other flights to quality/safety, there could be a gargantuan shortage of "high-quality collateral" amounting to as much as $11.2 trillion, we explained that demand for Treasury paper will increase with every passing month as the market realizes that traditional supply/demand dynamics in the rates market no longer exist and have been supplanted by regulatory demand-side technicals coupled with supply calculus which is predicated almost exclusively by what central banks do, or rather, how much Treasurys they monetize.
In retrospect, our observation also explains why everyone got the bond trade wrong in 2014, as everyone - most certainly Goldman Sachs and its clients - not only expected a global economic rebound (clearly that did not happen in 2014, when Chinese growth hit the brakes to record lows, and when both Japan and Europe re-entered recession absent GDP-fudging semantics), but were oblivious to the key considerations behind the high-quality collateral theme. Why, none other than Goldman in its Global Economics Weekly from June 27, 2012 and Fixed Income Monthly from July 2012 concluded that "there is not much evidence in favor of the explanation" of the high-quality collateral (HQC) thesis as a driver of Treasury demand. To see just how wrong Goldman was, compare the 10Y's Friday close with Goldman's 3.50% year-end target, and now add some 30x Total Return Swap leverage.
Which bring us to Friday afternoon, when as Goldman observes in a new note, "since then, the regulatory environment has further developed, with Dodd Frank now in place. Also, given this year’s rally in fixed income, the topic has become of interest again."
So where do we stand now that there is still trillions of explicit demand of HQC. Well, it seems that contrary to all expectations that the global recovery will stabilize inflation (or maybe deflation now plunging oil prices are actually a good thing: it seems Keynesian dogma was only kidding after all)?
Well, according to Goldman's own calculations, the demand squeeze for the High Quality Collateral that is global "Developed Market" Treasurys is about to go through the roof mostly thanks to central banks which will - even in the Fed's temporary hiatus from the monetization scene - soak up an unprecedented amount of Treasury collateral from both the primary issuance and secondary private market in their scramble to push global equity prices to unseen bubble levels and achieve the kind of Keynes-vindicating, demand-pull inflation that Russia was delighted to enjoy in the past several weeks.
How much? The answer: a lot, as in a whopping 20% collapse in supply, once the ECB joins the fray!
To compute 2015 gross and net issuance, we take data on medium- and long-term bonds maturing in 2015 from Bloomberg and use our own government deficit forecasts. We assume that G4 sovereigns fund two-thirds of the 2015 deficit by issuing bonds and one-third via bills. We net out central bank purchases from the estimated gross issuance, assuming that the Bank of Japan buys JPY120trn (the middle of the range set in the new guidelines published in October 2014 by the BoJ), and that the ECB purchases about EUR130bn of German government bonds. This is in line with our expectation that the ECB will announce a EUR500bn sovereign QE program in 2015Q1 and buy bonds according to each EMU country’s ECB capital key contribution.
The data on demand from different categories of investors are from the central banks’ flow of funds statistics. For the US, we also consider flows recorded by TIC data published by the US Treasury. We cumulate over a year quarterly net purchases of government medium- and long-term securities for various categories of investors. Because central banks' flow of funds data are available only with a significant lag, actual 2014 data include flows up to Q3 for the US and to Q2 for the other countries. We assume that in the quarters for which 2014 data are not yet available, purchases by the various categories of investors continue at the same average pace observed in the quarters for which we have data.
Yearly gross (bond issuance funding bond redemptions and the government deficit) and net (bond issuance funding the government deficit only) issuance of G4 government bonds, both including and excluding central bank purchases, declined significantly from 2012 to 2013, but not from 2013 to 2014.
For 2015, we project that the gross supply of G4 government bonds will decline by 4%. But, once we net out central banks’ purchases of government bonds, the 2015 supply available to private investors will fall by more (minus 20%). Scarcity will be concentrated in Bunds and JGBs, while we expect US Treasuries supply available to the private sector to increase and Gilts supply to be flat at 2014 levels.
Please note: it doesn't matter where the scarcity is located in a fungible, instantly interconnected, globalized world. Offshore dumb money, pension funds, and everyone else frontrunning them, will end up buying US Treasurys as a pair trade once spreads blow out once again, which means that with the 10Y Bund on its way to 0%, we may well see the US Treasury trade sub-2% and the spread to Bunds will still be a record wide.
How do the numbers stack up by geography?
In the US, 2015 issuance should increase slightly on the back of our forecast for a higher government deficit. Moreover, since the Fed has ended QE3, USTs supply available to the private sector will be $250bn greater than in 2014. In the UK, Gilt issuance will be little changed relative to 2014.
By contrast, the supply of Japanese and German government bonds available to the private sector will decline significantly. In Japan, gross JGB issuance, net of the BoJ’s purchase of JPY120trn (the middle of the range set in the new guidelines published in October 2014 by the BoJ), will fall to JPY22trn from JPY90trn in 2014.
Which is to be expected: recall that as we noted previous, Japan will monetize all gross issuance in 2015!
But the big wildcard is the ECB.
According to the government’s issuance schedule, Germany expects to issue about EUR147bn medium- and long-term nominal bonds and about EUR10-14bn inflation-linked securities to repay EUR155bn of maturing bonds, while the government budget will be roughly balanced. But, in Q1, we expect the ECB to announce a EUR500bn sovereign QE program and buy EMU government bonds according to each EMU country’s ECB capital key contribution. This implies that the ECB would purchase EUR130bn of German bonds, i.e., 90% of the 2015 gross issuance of German Bunds.
In case anyone missed the punchline, here it is again: "the ECB would purchase EUR130bn of German bonds, i.e., 90% of the 2015 gross issuance of German Bunds."
In short, between Europe and Japan, thanks to the BOJ and ECB, there will be literally no bonds that will make their way from the primary to the secondary market! Which means only one thing: those looking for the marginal, and only, source of high quality collateral in 2015, will find it coming right out of 1500 Pennsylvania Avenue, NW in Washington. And that assumes, very generously, that that other famous institution located on Constitution Avenue Northwest doesn't come out of hibernation and resume soaking up collateral on its own if and when the S&P500 finally corrects from its unprecedented, and manipulated, bubble levels.
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But even if one ignores all of the above, the only thing one really needs to know about where Treasurys are headed is the following chart from Goldman, ironically enough included in the same report as GS observed all of the above:
See you all at 1.5% or much lower.