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Monday, January 26, 2009

Long Bond Drops Most in 22 Years... A Trend or Volatility?

According to Brad Setser (former staff economist at the Treasury and current fellow at the Council of Foreign Relations):

In 2007, my best estimate is that China accounted for $120.3b of the $247.2b increase in the outstanding stock of marketable Treasuries not held by the Fed. China absorbed 49% of the net increase.

In 2008, my best estimate is that China bought $374.6 billion of the $1684.8 billion increase in the outstanding stock of marketable Treasuries not held by the Fed. China absorbed 22.2% of net issuance.

Thus, while China is an extremely important player in the Treasury market, purchasing 3x more Treasuries in 2008 than in 2007, they became a smaller relative player as demand from non-Chinese sources grew astronomically. So while there has been a media frenzy over Treasury Secretary Geithner's comments regarding Chinese currency manipulation and how China might react, it may be the lesser concern (back to Brad):
Obviously, it would be a big deal if China stopped buying and started selling. But it would be much bigger deal if private investors lost their appetite for Treasuries.
This past week we saw a massive sell off of long-dated Treasuries, supposed proof that this appetite is waning relative to the expected supply. According to Bloomberg:
Treasuries fell, with 30-year bonds losing the most this week in 22 years, as the U.S. readied $78 billion in debt sales over the next five days to finance fiscal stimulus spending projected to swell the deficit to $1 trillion.
While it is important to take note of any movement not seen in 20+ years, one week does not make a trend. In looking at the chart below, which details the historical 'week over week' change in the yield of the thirty year bond (in relative terms as a 30 bp move is obviously more drastic when yields are 2.9% vs. 10.6%), we see just how large an outlier this past week's move was (hint- the top right dot).

However, this chart also details how volatile the long bond has been... far more volatile in 2008-09 than at any other point in recent history and in both directions. The only previous time since 1980 the yield jumped or dropped at a similar magnitude was the week following Black Monday, October 1987. But that 100 bp drop (from ~10.2% to ~9.1%) was in response to a massive liquidity injection by Alan Greenspan following the 22.6% drop in the Dow on that single day.

Thus, while it is important to keep an eye on the long bond to see if the recent sell off does become a trend, please don't declare victory on your long Treasury shorts yet. Just remember, the Fed has another "weapon" available... the outright purchasing of Treasuries which may be on the way...