Steven Major reckons the stock and flow effect of the Fed’s withdrawal from the market has been overstated by bears in three ways.Getty Images/iStockphoto
Famed U.S. Treasury bull Steven Major is sticking to his guns: The sell-off in 10-year notes has run out of steam as the Federal Reserve's bid to downsize its $4.5-trillion (U.S.) balance sheet looks unlikely to send yields soaring in the world's largest bond market.
"Investors want to believe yields will go up as there are signs that the QE policy has had its day," Mr. Major, global head of fixed-income research at HSBC Holdings PLC, wrote in a report Wednesday, referring to quantitative easing. "But we think the stabilizing ballast of central bank balance sheets will contain yields with the normalization of Fed policy likely to be very gradual."
Treasuries in September suffered their worst losses in 10 months. Meanwhile, traders are holding the largest short position in over a decade as they weigh a slew of headwinds: A potential supply jump from the Fed's plan to reinvest fewer maturing proceeds from its bond holdings back into the market, a looser fiscal stance and the potential successor to Fed Chair Janet Yellen.
Not so fast, says Mr. Major. He's holding to his June projection that, by year-end, the benchmark note's yield will fall to 1.9 per cent – compared with 2.31 per cent currently – and will only return to today's level in the third quarter of 2018. (Bond yields and prices move inversely.)
He reckons the stock and flow effect of the Fed's withdrawal from the market has been overstated by bears in three ways.
First, there's limited scope for a material rise in the supply of long-dated obligations in the market while the duration profile of securities held at the Fed naturally decreases with time.
Second, the Treasury will also probably issue more bills – a sector of the curve that has shrunk as a proportion of the outstanding market – in the early stages of the balance-sheet runoff, which will be comfortably absorbed by investors.
Finally, the projected balance-sheet shrinkage will release only $1.3-trillion of bonds, while the QE program itself absorbed $3.6-trillion.
"The asymmetry of the entry and exit portfolio flows further argue against what appears to be a consensus 'what goes up must come down' narrative," Mr. Major concludes.
Bulls should take caution, however. Mr. Major's colleague, Lawrence Dyer, concedes that, for now, "a significant move to lower yields would require a surprise or crisis."
The Fed's move to downgrade its long-run estimate for the federal-funds rate that keeps supply and demand balanced should narrow the trading territory over the long haul, according to Mr. Dyer.
There's one area where HSBC joins an emerging consensus: the yield curve. The spread between long- and short-term U.S. Treasury bonds should steepen from post-crisis lows, Mr. Dyer says.
"Yields have moved up to the top of recent ranges but our forecasts have not changed," Mr. Major concludes.