Peter Tchir: What Does the Fed Actually Own?
In-depth analysis of the Fed's Treasury holdings reveals some interesting takeaways.
For the first time since I have been running the numbers, the Fed owns more than 50% of all bonds outstanding with maturity dates between 10 and 15 years.
I also find it fascinating that the 7- to 10-year part of the curve is almost 40% owned by the Fed.
Of the almost $2.1 trillion of Treasuries maturing in seven years and beyond, the Fed owns 43%.
I will spend an extra moment on the 20- to 30-year bonds because that is the bucket to which crowd favorites iShares Barclays 20+ Yr Treas. Bond ETF (NYSEARCA:TLT) and ProShares UltraShort Lehman 20+ Yr ETF (NYSEARCA:TBT) are tied.
I like to break this category into two buckets -- recent new issues and old bonds. I am using 5/15/2043 as the cut-off date. Bonds maturing in 20 to just under 29 years total $826 billion. The Fed owns 57% of those bonds.
The "free float" is all at the long end where the Fed owns less than 2% of the $197 billion outstanding.
I am not saying that the Fed has distorted the market beyond recognition or that it is responsible for the problems in the repo market, but...
The Repo Market
It is worth spending a minute on the "problems" in the repo market.
Not only are there a large number of fails, but on a regular basis, the on-the-run bonds are going "special" (or trade at a repo rate above the overnight general collateral rate).
According to Bloomberg, the 3-year Treasury repo rate is -0.45%, which is an improvement from -0.50%, but far from the general collateral rate of 0.1% or so.
To short the 3-year, you have to pay 0.45% plus the coupon of 0.875%. So it is expensive to be short right now.
Investors can buy 1-year T-bills and earn about 0.11% (which is about the general collateral rate) but they can also buy 3-year notes, earn the coupon (and take the duration risk), and pick up four times the T-bill rate by lending the bonds out.
So far, the pattern of repo failures has been consistent, though with increasing frequency and higher costs. The cost rises as we near the new issue date and then normalizes once the new issue is done.
This is where the Fed's influence on the market takes a surreal twist. The Fed has a new program that supports repos.
The Fed seems willing to lend out the bonds it owns. But no one wants to short these bonds because of the high coupon and the lack of liquidity.
So the Fed, which is willing to lend out its bonds, doesn't own the bonds that the market wants to be short. This is part of the overall problem. It's a relatively minor issue, but it supports my arguments about how the limited free float of Treasuries is very supportive of the long end of the curve. That leads us to our next level of detail.
The Rest of the Free Float
While insurance companies are not strictly buy-and-hold investors, it is reasonable to assume they take up some of the free float.
Using Bloomberg and recent Schedule-D filings, we find that insurance companies own $43 billion of the 20- to 30-year bonds, or just under 5% of the total.
It is interesting that insurance companies hold less of the old high-coupon bonds (maybe they sold them to the Fed?) and tend to own more recent new issues. It's possible that rates backed up enough to make it attractive for them to own these again.
There is a similar, though less pronounced trend in the insurance company filings around the 10-year point of the curve.
It is possible that this is exacerbating the repo situation.
Public Pension Funds
I have not yet figured out a good way to get this data in an aggregated form, so I went for the simplest approach. I took one of the largest Public Pension Funds' Treasury holdings as of June 2013.
It held $4.4 billion of 20-year and longer Treasuries at the time. That is about 20% of its Treasury portfolio, which had a significant allocation to TIPS.
I won't know what it did this past year until its next annual report comes out. I did confirm that during the period from June 2012 until June 2013, it increased its long bond holding.
According to the US Census Bureau, the top-100 largest US public pension funds had $3.22 trillion in assets, with $274 billion held in government securities.
I can run the numbers a couple of ways, based on the fund I analyzed, and wind up with a number around $50 billion. This could actually be conservative.
I have to add private pension fund plans to the mix, but so far have found very little data.
Other Central Banks
According to Treasury International Capital (TIC) System data, as of April 2014, the Major Foreign Holders of Treasury Securities held $364 billion in T-bills and $3.7 trillion in bonds and notes.
The fact that Belgium has become the third largest holder, up from eighth this time last year, has created some speculation about who it is buying for or if this is yet another unintended consequence of tight repo markets and the need to post collateral.
As of June 30, 2013, 3.2% of foreign holdings were in the 20- to 30-year maturity bucket. If it maintained that ratio, then it owns about $120 billion of the 20- to 30-year bucket.
Even more interesting is that as of June 2013, foreigners had 10.1% of their portfolios in the 7- to 10-year bucket. That would be an eye-popping $374 billion, or 70% of the float that the Fed doesn't own.
As far as I can tell, foreign entities' holdings fluctuate more than pension fund or even insurance company holdings. They may have reweighted their portfolios and some portion could be Treasury-Inflation Protected Securities, lessening their impact on the regular Treasury market.
If any of these holders is anything like the Fed or ECB, they are unlikely to want to take a loss, and given that they held on to these bonds during last year's May-June sell-off, it seems reasonable that they would still hold these relatively small percentages in their portfolios.
The numbers are so large that even being conservative and assuming some selling of the longer end, the "free float" taken up by foreign holders is meaningful.
One could easily make a case that the "free float" of 10- to 15-year bonds is virtually non-existent and the 20- to 30-year float may be as little as $300 billion. That's not a trivial amount, but it is far less imposing than $1 trillion, and it puts the short squeeze into perspective.
Pin the Tail on the 10-Year
Put on a blindfold. Then ask yourself where the 10-year Treasury would be if real growth was averaging 2.2% and inflation was consistently around 1.5%.
The answer is not obvious to me.
10-Year Yield Vs. GDP + PCE From 1992-2008:
The green line is GDP + PCE. The purple is the 10-Year US Treasury Yield (INDEXCBOE:TNX). It is clear that they track each other somewhat, though whether one is lagging or leading the other seems to change.
There are times when "growth" is 3.7% and Treasuries yielded about the same. There were times where Treasuries yielded over 5%. There have been times where growth has been much higher than 3.7% and yet yields were lower.
Clearly the direction and expectations matter.
While the economy is doing okay, growth and inflation remain stubbornly low, and as the Fed takes away liquidity, it is easy to imagine growth slowing rather than accelerating.
Without a doubt, 2.7% seems very low given the sort of growth and inflation for which we are hoping.
On the other hand...
Japanese 10-Year Bond Yields Since 1988:
Shorting JBGs has been called a "widowmaker" strategy, not because people shorted at 1% and yields slowly ground down to 0.8%, but because they went from 5% to 3% and then from 3% to 1%. I am not here to argue that we are Japan -- I just want to point out that many people went through similar analysis on Japan over the years, only to find that what seemed like insanely low yields would look high a year later.
So when looking at the 10-year and growth, it seems rates are too low, but we need those growth assumptions to happen to see yields move materially higher. At the same time, there is a deep short base, and a small free float. That should help offer resistance to any move to higher yields, at least at the long end.
Pin the Tail on the 10-Year
Put on a blindfold. Then ask yourself where Fed funds should be with inflation at 1.5%.
PCE Vs. Fed Funds:
The answer to this question seems pretty easy: 1.5% or higher. Until 2009, it was rare for the Fed to peg the short-term rate to generate negative real rates. Most of you are probably sick of seeing this chart, but again, this to me is crucial because once the Fed starts, this will be a natural attractor.
Curves Are Still Steep
Put on a blindfold. Then ask yourself where Fed Funds should be with inflation at 1.5%.
2-Year Vs. 30-Year Spread Since 1994:
So I am left suggesting again that it makes sense to be short the front end, short eurodollar futures through the 2015 to 2017 dates, and finally, having a curve trade on.
It is more difficult to make a case for higher rates at the long end, though it is possible.
The size of the short base coupled with a small free float makes me concerned we could see a short squeeze.
Yeilds could in fact move higher, but there are better ways of expressing that view than in the long bond.
Editor's Note: For more from Peter Tchir, check out his Fixed Income Report.
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