Analysis of the impact of QE1 conducted by Fed staffers concluded that yields (or term premiums) on longer-maturity securities were reduced by around 50bp. The market adjustment process at the conclusion of QE1 was relatively smooth. However, the bulk of the Fed's purchases in QE1 involved mortgage-backed securities, and MBS supply was unusually depressed as the buying wound down. Given that Treasury issuance is expected to continue at an extremely elevated clip for the foreseeable future, how will the market adjust to the loss of most Fed buying? In other words, who will be the marginal buyer of Treasuries going forward? Our analysis suggests that heavy buying by the largest foreign holders of Treasuries will be needed to avoid a back-up in yields.
Let's start by taking a look at Fed buying in a broader context of supply and demand in the Treasury market using the Federal Reserve Board's Flow of Funds Accounts. In 2010, net issuance by the Treasury Department amounted to about $1.6 trillion. Roughly half of these securities were purchased by foreign investors (more on this later). Other big buyers included households, pension funds and the Fed. Note that all of the Fed's purchases occurred during a relatively small window - they first started to acquire new Treasuries beginning in August 2010 (when the reinvestment policy for maturing MBS/agencies was altered), and the pace of buying ramped up in November with the onset of QE2.
The household sector of the flow of funds accounts is a special case. That's because the household category is a residual that includes all sectors for which the Fed does not have hard data - for example, domestically based hedge funds, endowments and foundations - as well as any data errors in sectors for which the Fed does have information. We suspect that some of the buying that shows up in the household sector in recent years reflects a reallocation to risk-free investments on the part of endowments and foundations during the height of the financial crisis. Also, there have no doubt been a lot of short-term trading bets in the Treasury market by leveraged investors. But it's worth noting that the household sector has been a net seller of Treasuries over the longer run. Indeed, we suspect that a significant portion of the spike in household purchases of Treasuries seen in the flow of funds accounts during 2009-10 reflects a data error. As the Fed collects additional information over time, the household sector's holdings of Treasuries have tended to be revised lower. For example, the originally published figure for household purchases of Treasuries in 2009 was $531 billion. In subsequent reports, this has been revised down to $385 billion, with corresponding upward adjustments seen in the foreign and pension categories.
There have long been questions surrounding the estimates for the foreign sector. The Fed relies on the Treasury International Capital System (TICS) data. But TICS-based estimates often differ substantially from estimates of flows into the US compiled by other nations, such as Japan. Also, the Treasury Department conducts benchmark surveys of foreign holdings (as opposed to purchases) of US assets at different points in time, and these figures often imply a much different flow of purchases during the relevant interval than seen in the TICS figures. Indeed, we suspect that a significant portion of the elevation in the household sector holdings of Treasuries seen in recent years actually reflects foreign investor activity that was not picked up by the TICS data due to reporting limitations. Quite simply, Treasuries are not a favored asset class of the typical household investor. And, the same can be said of endowments and foundations in general. Given the residual nature of the household category, any reported elevation in household sector buying should be viewed with a considerable degree of caution.
Looking at other investor categories, a few developments are worth highlighting. First, commercial banks are not typically big buyers of Treasuries, but loan demand softened during the recession and some banks boosted their securities holdings. However, recent trends suggest that the pace of Treasury buying has slowed as lending has begun to stabilize. Going forward, proposed capital and liquidity requirements (i.e., Basel III) could have an important impact on bank portfolio behavior, but the extent of the regulatory changes - and thus the extent of the banking sector's response - remains somewhat unclear at this point. Second, inflows to fixed income mutual funds have spiked in recent years, but only a modest amount of these investments have been directed into the Treasury market. The prospects for additional upside in demand from this sector seem limited, at best.
The pension category has also shown a significant pick-up in the pace of Treasury buying in recent years. However, much of this upswing in demand seems to mirror a similar decline in holdings of MBS and thus appears to be part of an asset reallocation within fixed income. Given that pension fund holdings of MBS are now at such a low level ($170 billion), the scope for further reallocation seems limited to us. Finally, money market funds continue to lose assets in a near-zero rate environment, and while inflows should pick up when rates eventually rise, renewed buying from this category should be confined to the bill sector.
The Fed's recent role in the Treasury market can be better seen by looking at 1H11 data. During this period, we estimate that the share of net issuance of coupons purchased by the Fed alone will be 88%. Assuming that the Fed ceases reinvestment of MBS, followed shortly thereafter by ceasing reinvestment of maturing Treasuries (as described in Normalizing the Fed's Balance Sheet), the Fed will start adding to the market's supply burden in 2012.
With the Fed pretty much out of the picture after June, it seems clear that foreign demand for Treasuries holds the key going forward. While market perception is that foreign central banks and sovereign wealth funds play a dominant role in the Treasury market, the TICS data show much heavier buying of Treasuries by private foreign investors in recent years. During the past year or so, the biggest foreign buyers of Treasuries have been domiciled in the UK, Japan and Canada (in that order). Indeed, in 1Q11, the TICS data reveal that net purchases of Treasuries from the UK ($63 billion), Japan ($27 billion) and Canada ($17 billion) accounted for all of the total $104 billion of net foreign purchases. The same general pattern is evident in the data for 2H10.
However, these figures may be misleading in terms of the source of recent flows. The TICS data only capture the initial overseas transaction. If a dealer based in the UK acquires a security from its US-based parent or subsidiary and subsequently sells that security to a client in Asia, the latter transaction will not be captured by TICS. In fact, TICS does annual benchmark ownership surveys that highlight the shortcomings of the flow data. The most recent benchmark survey was for June 2010 and the estimated amount of China's holdings of Treasuries was boosted by $268 billion (from $844 billion to $1.12 trillion), while the UK was lowed by $269 billion (from $364 billion to $95 billion). There were also significant upward adjustments to estimated Treasury holdings in Taiwan and Russia. In the 2009 benchmark survey, China's holdings were revised up by $139 billion while the UK holdings were revised down by $122 billion. Again, there were notable upward adjustments in Russia and Taiwan. And, in 2008, the UK was revised down by more than $200 billion, but China was revised only slightly ($31 billion) higher. Meanwhile, Japan, Taiwan and Russia were revised higher. The important point here is that the country breakdowns in the TICS transaction data can be highly misleading. So, while foreign investor demand appears to hold the key to the Treasury market post QE2, shortcomings in the data make it difficult to identify the sources of recent foreign buying.
At the end of the day, continued heavy buying by the largest foreign holders of Treasuries will probably be necessary to prevent a back-up in yields post QE2. Annual benchmarking means that TICS estimates of current holdings of Treasuries are reasonably accurate.
Volatility in rates market likely to increase. We also believe that the post-QE2 market adjustment is likely to be data-dependent. The rates market reaction to incoming information in recent months has appeared to be asymmetrical - i.e., Treasuries rally more than they ‘normally' would in response to favorable news and sell off less in response to bad news. A more symmetrical response would be consistent with a gradual market adjustment to higher real yields over time. Finally, we would note that even if foreign investors step up and absorb all of the securities that the Fed has been buying, they won't provide details on the amount and timing of their purchases several weeks in advance - as the Fed currently does. So, at the very least, we should see greater market volatility once the Fed moves to the sidelines.
House Prices: 2-Year Outlook: 10% Fall
Our forecast: -3% 2011 4Q/4Q; -7% 2012 4Q/4QConsensus: -1.9% 2011 4Q/4Q; +2.1% 2012 4Q/4QOBR: -2.3% in 2011 (change on a year earlier); 0.1% in 2012
We still expect a further fall in UK house prices. The supply recovery looks likely to be relatively weak, but we think that demand will be dampened by continued weak real household disposable income growth and likely rising mortgage rates. We build in an assumption of a 150bp rise in the policy rate over the period, although do assume some compression of mortgage spreads that acts as an offset. We don't expect any significant further increase in the availability of higher loan-to-value mortgages and expect only modest improvements in credit availability more broadly. Valuations continue to look stretched and affordability hasn't improved much once higher required deposits are taken into account.
House price expectations also play an important role in our house price model and we assume that a proportion of expectations are formed in a backward-looking way. This ‘backwards glance' takes in more periods of relatively weak house prices as we roll the model forward.
Bear and bull case: Our bear case assumes that house prices undergo a bigger correction for existing overvaluation (and incorporate a bit of overshooting). Our bull case would be broadly consistent with the projections of our housing model if we assumed flat real mortgage rates over the next year-and-a-half but also allows for a modest degree of correction from current levels of overvaluation.
House Prices: 2-5 Year Outlook Obscured by Volatility
Over the next 2-5 years, we see scope for significant volatility in the housing market but do not have a firm directional view: 1) Supply may continue to recover only weakly, leaving house prices vulnerable to fluctuations in demand. 2) Mortgage spreads may also be volatile. 3) Real interest rates are also likely to be volatile. In the medium term, we think that inflation pressures will be relatively strong on average, prompting further rate rises from the bank as it tries to get inflation back to target. However, with the real economy continuing to go through a period of transition towards being a more export- and investment-led economy and the banking sector likely undergoing significant changes too, growth and financial conditions may fluctuate more than in the pre-crisis years and increase the volatility of any interest rate path. 4) There is the potential for further ‘step changes' in housing demand. The transition to post-crisis tighter credit conditions is likely to be ongoing and there is potential for further changes in mortgage market regulation.
Implications for UK Banks
UK Banks analyst, Chris Manners, analyses the impact of our expected house price falls of 10% from 4Q10 levels on the UK banks and sees three negative effects.
1. Higher impairment charges in the mortgage book likely
We expect higher impairment charges due to i) higher default probability as arrears rates climb; and ii) higher loss severity in event of default as collateral values (i.e., house prices) fall.
2. Higher capital requirements possible as modelling assumption could become more conservative
As prices fall, we expect that UK banks would increase the ‘loss given default' assumptions they use, as recoveries on collateral would be lower. This would increase the risk weight on mortgage exposures, and hence adversely impact capital ratios.
3. Elevated funding costs constraining mortgage growth
Currently, funding costs are elevated and there is little appetite for re-gearing by homeowners. If house prices continue to drift down, we would expect that spreads on UK banks' debt would remain elevated. This funding cost would act as a constraint on new mortgage lending and also would act as a drag anchor on house prices as there is less leverage to support the sector.
For full details, see UK Economics & Banks: Why We Think UK House Prices Will Fall 10%: Lloyds Most Exposed, May 31, 2011.
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