Safety, risk, T bonds & equities

The US flow of funds data confirmed that in Q4 2011, foreign central banks began selling US Treasury bonds. Indeed, over the quarter, foreign central banks reduced their T bond and Agency debt holdings by $30bn (this is the actual data which is not seasonally adjusted or expressed at an annualised rate) but, despite this event, US Treasury bond prices rallied over the quarter. What made this rally even more interesting was that the Treasury issued $325bn of bonds over the quarter on the same unadjusted basis.

On the purchase side in the government bond markets, foreign private sector investors acquired $100bn, which may have reflected the appetite for perceived safety, and the remaining c$250bn of T bond ‘supply’, which by default had to be absorbed by the domestic private sector in the US, was accounted for by households, family offices and domestic hedge funds (only $4bn), the commercial banks ($34bn); pension funds ($20bn); mutual funds ($84bn) and the investment banks ($90bn).

In terms of the likely rationales behind these purchases, we can assume that the households (or more probably the family offices etc that are included within the household sector data) and mutual fund sectors were simply looking for a safe haven during the Euro Crisis. The commercial banks’ modest level of activity at that time probably represented a half-hearted and capital-constrained attempt to ride the yield curve but the $100bn of T bonds purchased by the investment banks over the quarter is perhaps the most difficult to explain. At first sight, this may have been risk aversion, but in order to finance their balance sheets and implicitly their T bond holdings, the investment banks still had to increase their level of repo borrowing and borrowing from their affiliated institutions and this could suggest a possible degree of increased risk appetite. Looking back on prior spikes in investment bank demand, such as Q3 2007 (immediately post-Lehman), during the LTCM Crisis, the beginning of the NASDAQ Bust, after 9-11, the deflation scare of 2003 and the 2004 corporate bond market ‘event’, it may be the extra demand for Treasuries reflected the demand of the investment banks’ own creditors. After all, during times of financial stress, the first thing that creditors or lenders within the internal workings of the financial system do is to cut their unsecured lending and instead demand collateral when they lend and, in a world in which the rating agencies have sharply reduced the supply of eligible collateral via their downgrades, Treasury bonds stand out relatively prominently as the collateral of choice. Hence, when the global financial system stumbles, we may not only see increased ‘safe haven flows’ into T bonds but also a sharp rise in the demand for T bonds for use as collateral by the investment banks and others.

However as bond prices rise, there becomes not only a valuation reason to switch back into risk assets but also potentially a greater supply of collateral within the system that can be mobilised in the event of lenders returning to the credit system. Therefore, with perceived ‘good news’, such as the ECB’s announcement of the LTROs, the financial markets are in a sense already primed to launch a substantial real and leveraged flow of funds back into the risk markets. Moreover, if the level of risk appetite increases sufficiently, some of the would-be leveraged investors may find that they still need to buy T bonds in order to guarantee their borrowings and this can act as a prop for bond prices in the short term, even as risk appetite returns to the markets.

This may be what was happening in the USA until recently. However, it is also true that as risk appetite returns, the requirements for collateral may soften and investors may also feel that they no longer need to hold assets in a safe haven. At this point, as the safe haven and collateral-related demand for bonds eases and bond prices may begin to fall sharply but, as yields rise, it is also true that risk assets will start to look relatively less attractive and the supply of collateral in the system that will be available during any new period of stress will also tend to fall.

There is some technical sensitivity of risk asset pricing to T bond yields and arguably if Treasury ten year yields were to breach 2.85%, then the equity market could begin to look expensive again.

As a tentative conclusion, there is a risk that if the current rise in global economic confidence results in a decline in the perceived need for safe havens and collateral in the system, then the rally in risk assets might strangely prove self limiting, just as Japan’s rallies did during the 1990s and early 2000s.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla