In response to the impact of the epidemic, the United States adopted an extraordinary fiscal and monetary policy in 2020. The U.S. Congress has passed five rounds of fiscal stimulus bills. The federal government’s deficit has surged and the scale of U.S. Treasury bond issuance has risen sharply; the Federal Reserve lowered its benchmark interest rate by 150 BPs, returning to the era of zero interest rates. The huge financial burden and the long-term low interest rate environment have broken the previous balance of supply and demand in the US Treasury bond market, and investor behavior has also changed accordingly.
U.S. Treasury Bond Investor Structure and the Impact of the Epidemic
According to the attributes of investors, U.S. Treasury bonds can be divided into Intragovernmental Holdings and Debt Held by the Public. According to data from the US Treasury Department, the balance of US Treasury bonds at the end of 2020 was US$27.7 trillion, an increase of 19.6% year-on-year, accounting for 132% of GDP, up 25% year-on-year. Among them, the scale of public holdings is 21.6 trillion US dollars, accounting for 78%, and the remaining approximately 6 trillion US dollars are held by US government agencies.
The demand for government bonds of government agencies is stable and is not greatly affected by market interest rates. Therefore, this article will focus on the public holdings, including monetary authorities, banks, pension funds, insurance companies, mutual funds, state and local governments, overseas and international investments And others.
According to data from the Securities Industry and Financial Markets Association (SIFMA), as of the third quarter of 2020, the balance of U.S. Treasury bonds held by the public was US$24 trillion, of which foreign investors held US$7.2 trillion, accounting for 30%; in the United States Investors hold 16.8 trillion US dollars, accounting for 70%. Among domestic investors in the United States, the Federal Reserve, mutual funds, and pension funds hold larger positions, accounting for 21%, 16%, and 12%, respectively.
In 2020, the Fed implemented a large-scale QE. As of the end of the third quarter, the Fed had increased its holdings of US$2.6 trillion in Treasury bonds to US$5.15 trillion, an increase of 103% from the end of 2019. The loose monetary environment drove the U.S. Treasury yields to fall sharply. The U.S. 10-year Treasury yields fell from 1.92% at the end of 2019 to 0.93% at the end of 2020, reaching a minimum of 0.52% during the period.
Under the low interest rate environment, overseas investors and domestic financial institutions in the United States are still pouring into the Treasury bond market. Among them, mutual funds, overseas investors and commercial banks increased their holdings by US$1.2 trillion, US$360 billion and US$280 billion respectively from the end of 2019, while individual investors and pension funds reduced their holdings by US$259.7 billion and US$31.8 billion respectively.
Figure 1: US Treasury bonds held by the government and the public
Data source: US Treasury Department, SIFMA
Figure 2: Percentage of U.S. Treasuries held by various institutions
Data source: US Treasury Department, SIFMA
Figure 3: Changes in U.S. Treasury bond holdings by various types of investors in 2020
Data source: SIFMA. Note: The data is as of the third quarter of 2020.
Figure 4: U.S. Treasury bonds held by overseas investors
Data source: Wind
Analysis on the Behavior of U.S. Treasury Bond Investors
Under the low interest rate environment, the investment demand for US Treasury bonds remains strong, mainly due to differences in the behavioral characteristics of different types of investors. Different types of investors have different capital durations, return requirements, and risk preferences. There are differences in leverage levels and asset allocation strategies, and their sensitivity to changes in interest rates is also different. For allocating funds, such as pension funds, individual investors and overseas investors, they pursue stable coupon income, prefer long-term products, and tend to increase their allocation during the period of rising interest rates. Transactional institutions represented by mutual funds and banks have flexible strategies, high turnover rates, and use of leverage. They are highly sensitive to interest rate fluctuations. They mainly allocate medium and short duration varieties, and tend to be in the window period when interest rates are falling. Increase the position to buy, earn a return from the band operation.
Over the past 10 years, overseas investors have been the main force in the allocation of U.S. Treasury bonds, but their holdings as a proportion of public holdings have continued to decline. At the end of the third quarter of last year, the share of overseas investors’ holdings decreased by 5 percentage points to 30% compared to the end of 2019, the lowest since 2004. Compared with other types of investors, the allocation of overseas investors has weakened. The main reason is that the United States has maintained a low interest rate environment for a long time after the subprime mortgage crisis. The absolute yield of U.S. Treasury bonds has declined, while risky assets such as U.S. stocks and corporate bonds have declined. The performance was good and part of the investment funds were diverted.
However, the long-term trend of overseas investors to increase their holdings has not changed. As the degree of negative interest rates in economies such as the Eurozone and Japan have deepened, the relative advantages of US Treasury bonds in terms of security, liquidity, and investment returns have become prominent. Affected by the Fed’s interest rate cut, the yields of U.S. Treasury bonds fell sharply in 2020, but they are still at a relatively high level compared with other developed countries and regions. At the same time, a weaker U.S. dollar index has cut the cost of foreign exchange hedging for overseas investors. At the end of 2020, the euro-hedged U.S. 10-year treasury bond yield was 0.09%, 66 BPs higher than the German 10-year treasury bond yield; the yen-hedged U.S. 10-year treasury bond yield was 0.42%, which was higher than that of Japan’s 10-year treasury bond. Treasury bond yields are as high as 40BPs.
In 2020, the U.S. Treasury Department issued a large amount of cash to U.S. residents through multiple rounds of rescue programs. The U.S. personal savings rate has risen sharply from approximately 8% before the epidemic to 13.7%. At the same time, the Federal Reserve has taken the hands of non-bank financial institutions in the process of implementing QE. The purchase of US Treasury bonds has led to a substantial increase in bank deposits. In 2020, the U.S. banking system reserves will climb from USD 1.7 trillion at the end of 2019 to USD 2.85 trillion at the end of the third quarter of 2020. The U.S. Treasury Department estimates that after incorporating the $1.2 trillion high-quality liquid assets (HQLA) held by banks, the actual LCR indicator of the U.S. banking industry is as high as 144%, indicating that the banking system is over-liquid.
While bank deposits are rising rapidly, the scale of loans has shrunk. In 2020, the quarter-on-quarter growth rate of loans of major U.S. banks continued to decline, and even fell to a negative value in the third and fourth quarters. The widening gap between the deposit and loan balances of commercial banks shows that the pessimistic expectations of the economic outlook have suppressed the investment and production activities of enterprises. Large-scale rescue funds have been directly converted into private sector savings and have not flowed into the real economy, stimulating the growth of total social demand.
In contrast, the scale of bond assets held by banks has steadily increased. At the end of 2020, the scale of treasury bonds and agency bonds held by commercial banks increased by US$758 billion to US$3.75 trillion from the end of 2019. The impact of the epidemic has led to a reduction in market risk appetite and insufficient willingness of banks to lend. Treasury bonds not only provide safe and stable income, but also meet the requirements of liquidity supervision. Therefore, commercial banks have increased their holdings of US Treasury bonds.
Mutual funds play an important role in federal debt financing. Since 2015, the rapid expansion of mutual funds in the U.S. market has to a certain extent promoted mutual funds to increase their holdings of U.S. Treasury bonds. Among them, money market funds are the main holding force of short-term treasury bills (T-bill), with a market share of up to 40%. Bond funds have a high demand for medium and long-term treasury bonds, while equity and hybrid funds usually hold a certain proportion of risk-free assets for risk hedging while allocating equity assets. Holding treasury bonds can diversify the risk of investment portfolios. It played an important role in reducing portfolio volatility.
In 2020, a series of easing measures by the Federal Reserve will push asset prices to historical highs. In 2020, the full-year return of the Bloomberg Barclays US Treasury Index reached 7.9%, and the net assets of US bond funds increased by US$500 billion during the same period. The annual returns of the S&P 500 Index and the Nasdaq Index reached 16.3% and 43%, respectively. The net assets of US equity and hybrid funds also expanded by US$1.35 trillion and US$40 billion respectively. Excessive reserves in the banking system have spawned a large amount of demand for liquid asset management, driving the growth of money market funds. The accelerated expansion of the asset scale of mutual funds has boosted the allocation of U.S. Treasury bonds.
Figure 5: Growth of U.S. mutual fund assets
Data source: Wind
Figure 6: The size of net assets of each type of mutual fund
Data source: Wind
Late-stage investor behavior prediction
Since 2021, the medium and long-term yields of U.S. Treasury bonds have risen rapidly. At the beginning of the year, the U.S. 10-year Treasury bond yield exceeded 1% and hit 1.3% on February 16, the highest point since February 27, 2020. As the Fed’s monetary policy remains loose, short-term yields are relatively stable, and the yield curve continues to steepen, the (10-2)-year maturity spread has widened to nearly 118 BPs, a new high since March 2017.
In summary, driven by Biden’s new rescue plan, the net issuance of US Treasury bonds in 2021 is likely to exceed market expectations. At the same time, under the established bond purchase plan, the Fed’s holdings will decline, and the superimposed inflation expectations will rebound. Factors such as pushing up U.S. Treasury bond yields have diverged the behavior of other types of investors.
According to the forecasts of the U.S. Department of the Treasury, primary dealers and the U.S. Congressional Budget Office (CBO), in the 2021 trillion fiscal year, the net issuance of Treasury bonds will be between 1.66 trillion and 2.65 trillion U.S. dollars, a significant increase from the 2020 fiscal year. cut back. But none of the above predictions include the $1.9 trillion rescue bill led by the Biden administration. Under the political structure of the “Democratic Sweep” (Blue Sweep), it is more conducive to the implementation of a new round of epidemic relief bills. If the fiscal stimulus is implemented as scheduled, the net issuance of US Treasury bonds in fiscal 2021 will be higher than the agency’s forecast results.
The size of the Fed’s holdings of Treasury bonds is closely related to its asset purchase plan. The Federal Reserve’s January FOMC meeting announced that it would maintain the current bond purchase scale, which is to buy US$80 billion in Treasury bonds and US$40 billion in MBS every month. Accordingly, the Fed will increase its holdings of US$960 billion in Treasury bonds in 2021, a sharp drop in the size of the increase from the US$2.3 trillion in 2020, which may cause the Fed’s holdings to fall.
Except for the Federal Reserve, other types of investor allocation behavior are obviously affected by changes in U.S. Treasury yields. In 2021, the accelerated recovery of the U.S. economy, increased fiscal stimulus, and rising inflation expectations will jointly drive the long-term yields of U.S. Treasury bonds to fluctuate upwards. Allocation funds such as pension funds, individual investors, and overseas investors are expected to increase the U.S. The intensity of national debt allocation.
Commercial banks have strong demand for U.S. Treasury bonds. As shown in Table 2, the Ministry of Finance predicts that the excess reserves of the banking system will continue to increase by US$2.1 trillion in 2021, and the situation of excess liquidity will further intensify. In the early stages of the US economic recovery, corporate credit qualifications were slowly restored, loan growth was difficult to see a significant improvement, and capital diversion for investment bonds was limited; on the other hand, the credit spread of corporate bonds was at a historically low level, and there was insufficient room for spread protection. Investment risk is relatively high, so government bonds are still the first choice for bank asset allocation. The Treasury Department predicts that from 2021 to 2022, the U.S. banking industry will accumulatively increase its holdings of US$1.8 trillion in Treasury bonds.
The investment types of mutual funds are diversified, so the relationship between their investment behavior and the interest rate environment is more complicated. The liquidity provided by the Federal Reserve through QE and the excess reserves of the banking system will provide large-scale incremental funds for mutual funds, especially money market funds, to support the allocation of short-term Treasury bills. At the same time, in the upward phase of interest rates, funds invested in corporate bonds, especially high-yield bonds, are expected to return to relatively low-risk varieties, such as treasury bonds, municipal bonds, and agency bonds. However, the rebound in U.S. Treasury bond yields may bring pressure to adjust the valuation of the stock market and restrict the asset allocation of equity funds. It is expected that the increase in mutual fund holdings will be marginally weaker than in 2020.