Market Musings
Rates, FX and Commodities Strategy
21 October 2015 | New York
Look Who’s Buying
 Most of the traditional and price insensitive buyers of Treasuries
(the Fed, foreign official reserves, and commercial banks)
appear to have stepped away in 2015.

Instead, the emerging buyers of Treasuries have become
mutual funds and we believe, private foreign investors. These
investors are more price sensitive, not just outright, but relative
to alternative investments. This should continue to support
strong correlation between long end rates and risky assets, as
well as global rates.
Shifting tides in demand
Recent market attention has been focused predominantly on large
selling of Treasury securities by foreign central banks. This has
occurred with the Fed no longer adding to its portfolio and many
immediate commercial bank LCR needs being fulfilled, which has
served to keep bank demand in check. Conspicuously absent from
the recent discussion have nevertheless been the key sources of
demand that have allowed Treasury yields to remain low despite
notable selling pressure. After all, with China selling $200bn in
Treasuries since the start of the year (according to TIC data), the
decline in Treasury yields during this period suggests that other
buyers have been able to more than offset the selling pressure.
In this piece we analyze the various sources of demand for
Treasuries detailed by the Federal Reserve’s Flow of Funds release.
This is an extremely comprehensive source, but is lagged by more
than 3 months. We therefore utilize higher frequency indicators to
help provide a more real-time reading of demand. We highlight that
mutual funds and households (a residual, or catch-all item in the Fed
release) have taken over from the Fed, foreigners and banks as the
key sources of demand for Treasuries in 2015 (Figure 1). This could
have some interesting market implications.
Figure 1: Breakdown of Treasury Demand by Buyer
2013
2014
H1 2015
858
736
-63
Marketable
806
647
190
Nonmarketable
52
89
-253
Federal Reserve
543
253
0
Foreign
222
362
18
Banks
-35
195
5
Broker Dealers
-110
-76
-17
Households
52
-65
118
Mutual fund
55
-13
41
Money market funds
30
-75
-15
State and Local Govt
-11
37
5
Insurance Companies
-6
20
8
Govt Retirement Funds
123
75
-254
Private Pension Funds
-12
14
8
Nonfinancial Business
5
2
3
Other*
-7
13
16
560
487
Total
Budget Deficit (CY)
Source: Federal Reserve, TD Securities
137
All figures in $ billion.
* “Other” includes closed-end funds, ETFs, GSEs, ABS issuers, and holding companies.
Foreign official demand: on the decline
Foreign official accounts have been a major source of demand for
Treasuries since 2004, when FX reserve accumulation began to
accelerate as countries tried to prevent appreciation in their
currencies relative to the dollar. World reserves grew from $2.8tn in
2004 to $6.9tn in September 2008, and to $12tn by July 2014. Since
mid-2014, however, reserves have begun to decline, with the most
noteworthy decline coming in China. Total world reserves have fallen
from $12tn to $11.3tn in the past year, led by China, OPEC, Korea,
and followed closely by other emerging markets. This has been
driven by slower EM growth as well as capital outflows from EMs as
investors anticipated imminent Fed rate hikes.
Treasury TIC data suggests that most of the foreign demand for
Treasuries came from foreign official accounts (we include Belgium
as being official since it is a proxy for central bank buying). In 2014, of
Market Musings
21 October 2015 | TD Securities | New York
the $362bn in total foreign demand for Treasuries, we estimate that
$137bn emanated from foreign official accounts (Figure 2).
Figure 1 shows that total foreign demand accounted for $362bn in
Treasuries in 2014 but slowed to a meager $18bn in H1 2015. We
argue that the picture likely looks much worse in H2 given further run
-off in FX reserves after the devaluation of the RMB in August.
Treasury TIC data suggests that foreigners sold a total of $88bn in
July and August, and we believe that holdings continued to decline in
September as well, with Chinese reserves falling another $43bn
during the month. Figure 3 highlights that even though Treasuries
comprise about 40% of China’s reserves, much of the recent decline
in reserves has been met by a disproportionate amount of Treasury
selling.
Federal Reserve: no more QE, but reinvestments
Following the end of QE3, the Fed is no longer buying Treasury
securities (and MBS). Thus it is natural for this buyer base to decline
in importance. This is particularly important for the long end for the
curve, since Treasury buying removed a large chunk of long duration
paper during Operation Twist and QE3. We expect the Fed to
continue reinvesting maturing Treasuries throughout 2016, which
would keep demand from this category unchanged at zero. However
once reinvestment ends, maturing Fed issues will add additional
supply to the market since Treasury will need to issue extra paper.
This is particularly an issue in 2017 and 2018, when we estimate a
respective $194bn and $373bn of paper rolls off the Fed balance
sheet.
Banks: LCR no longer a binding constraint
Commercial banks have historically not been large buyers of
Treasuries, but they emerged as one of the strongest buyers in 2014
due to Liquidity Coverage Ratio (LCR) needs. We believe that the
run-up in bank Treasury holdings was predominantly driven by LCR
needs (rather than a market view about Treasury yields or MBS
spreads), since banks’ advances from the FHLB system increased
considerably during the same period when banks purchased $210bn
in Treasuries between late-2013 and early-2015.
There has been little buying of Treasuries by banks in 2015,
suggesting that many have reached full LCR compliance and may
currently be focused on optimization, replacing some of their
Treasuries with higher-yielding Level 1 assets. The Fed’s H8 release
provides a more high frequency indicator of bank demand,
suggesting that banks have actually sold $9bn in Treasuries this
year. MBS holdings, in contrast, have risen $124bn since the start of
2015 (Figure 4). We do not expect Treasury demand to repeat 2014
levels going forward as banks continue to focus on optimizing their
LCR strategies.
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Market Musings
21 October 2015 | TD Securities | New York
Figure 7: Net Marketable Issuance Has Declined
Considerably
Year Treasuries TIPS FRNs Total
Net
Bills
Maturing
Net
Issuance
2011
2004
131
0
2135
-252
791
1344
2012
2004
149
0
2153
108
1184
969
2013
1985
155
0
2140
-37
1297
843
2014
1896
155
164
2215
-181
1447
768
2015
1803
155
164
2122
-107
1425
697
Source: Treasury, TD Securities
Broker dealers: SLR forcing reduction
While broker dealer holdings of Treasuries have continued to decline
steadily in recent years due to the rising cost of dealer balance sheet
due to SLR, recent central bank selling of Treasuries has ended up
on dealer balance sheets (Figure 5). Weekly Fed data shows that
dealer holdings of nominal coupon securities reached a high of
$60bn during the recent selloff—the highest level since late-2013.
While the Flow of Funds data shows that broker dealer balance
sheets declined by $17bn in H1 2015, we expect recent selling to
help push the figure higher in August and September, offsetting the
lower H1 data. This higher demand should nevertheless prove
temporary as dealers should look to offload this paper over time.
Mutual funds and households (residual)
Mutual funds have emerged as one of the strongest sources of
Treasury demand so far in H1, buying $82bn on an annualized
basis. We believe that this is a function of hedging demand against
risky assets as well as a shift away from other lower-yielding bond
markets globally. By the end of January 2015 (when the ECB
announced QE), 10yr Treasuries yielded 1.64%, compared with
similar maturity Bunds at just 0.30%, JGBs at 0.28% and Gilts at
1.33%. We expect this source of demand to have strengthened in
H2 2015 given the risk-off move that occurred in August and
September, and expectations of more easing by the ECB and BoJ.
The “household” sector is a little more difficult to explain. It is a
residual or catch-all in the Flow of Funds report, which measures
“pure households” but also includes any demand that was not
captured by the other categories. Note that “pure households” tend
to buy US savings securities rather than marketable debt.
Interestingly, total US savings certificates have shrunk by $2.8bn this
year, after declining by $3.3bn and $3.2bn in 2013 and 2014,
respectively.
* All figures in $ billion.
Thus we believe that the Flow of Funds household sector is
capturing some other buyer base (rather than pure households)
demanding more Treasuries. Growth in this category has often been
associated with hedge funds, since there is no other category that
can capture this investor base. However we find it difficult to explain
such large demand for Treasuries since hedge funds often need to
employ a great deal of leverage—a difficult undertaking in a balance
sheet-constrained world. Instead we believe this category may be
reflecting private foreign demand as well as some mutual fund
demand that was not entirely being captured by mutual fund flow.
The supply story: debt ceiling
nonmarketable debt and bills
effect
on
While shifts in demand for Treasuries have been more dramatic in
2015, there have been important changes in supply as well—both
structural and one-off.

Structural: Due to a stronger economy as well as the budget
accord in 2011, the deficit has been declining in recent years. In
fact, improving economic growth momentum since the crisis
has allowed revenues to rise to 18% of GDP from a low of 14%
in 2009. The decline in outlays has been equally dramatic, with
outlays falling to 20% of GDP today from 25% in 2009. Outlays
have nevertheless seen some stabilization at these lower levels
over the past two years, while stronger than expected economic
growth has allowed revenues to continue expanding steadily
(Figure 6). Improving budget dynamics have allowed Treasury
to considerably cut back net issuance. We estimate that net
coupon issuance (including floaters and TIPS) declined by
$71bn in 2015 compared with 2014 (Figure 7).

One-off: With the debt ceiling rapidly approaching, Treasury
began to cut bill issuance in August and started to cut
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Market Musings
21 October 2015 | TD Securities | New York
nonmarketable debt issuance in May. Since the start of
extraordinary measures, nonmarketable debt has declined by
$210bn and bills outstanding have declined by another $210bn,
with $42bn more expected in the run-up to the X-date. This is
consistent with the drop in holdings by government retirement
funds (nonmarketable debt) and money market mutual funds
(Figure 1). We do not expect this decline to persist; assuming
that the debt ceiling is raised by the November 3 X-date, bills
and nonmarketable debt issuance should rise rapidly.
Market implications
Even though supply and demand technically do balance each other
out, the more important question is one of the price clearing level.
The biggest market impact of the supply-demand technical is on
term premium (the component of rates that is independent of Fed
expectations). According to the Kim-Wright model, the 10yr term
premium has been largely range bound all year despite this rotation
of key Treasury buyers. This indicates that the stepping away of the
traditional buyers has not impacted term premium so far. The decline
in 10yr yields has been more a function of Fed expectations, but the
stability of term premiums is still impressive.
We believe that there are two main market implications of this
shifting demand technical:

Greater volatility: Price insensitive buyers (such as foreign
officials, banks, and the Fed) have been replaced by price
sensitive buyers. This suggests that demand for Treasuries
could become somewhat more volatile as the market searches
for the marginal buyer. This can argue for more realized volatility
—a factor already vividly reflected in this year’s volatile price
action.

Greater cross asset correlations: However the “price” in this
context of price sensitive buyers does not refer solely to
Treasury prices, but also to the prices of alternative investments.
If equities fall, mutual fund safe haven demand for Treasuries
should increase. Similarly, low global bond yields can create
demand for higher yielding Treasuries. Thus we argue that the
correlation between 10yr Treasury yields and risky assets as
well as global developed market rates should remain strong.
Priya Misra, Gennadiy Goldberg, Cheng Chen
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Market Musings
21 October 2015 | TD Securities | New York
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Market Musings
21 October 2015 | TD Securities | New York
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