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Just who or what is holding down U.S. government borrowing rates has become one the big financial questions of the year - at least for those who think the Fed’s ongoing bond-buying program is not a good enough explanation.

The puzzling slide in Treasury yields around second-quarter inflation scares has fingers pointing at several culprits - wily Federal Reserve communications on ‘transitory’ price pressures, leakage from a temporary cash flood in money markets, wrongfooted speculators or even skewed debt sale dynamics.

Either way, 10-year Treasury borrowing rates are sailing into midyear 25 basis points below where they started the quarter, even as core annual U.S. inflation readings exceeded forecasts in April and May to hit their highest in almost 30 years at 3.8%.

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Ten-year U.S. inflation expectations embedded in the inflation-protected bond market are, at 2.38%, almost exactly where they were at the end of March.

All priced in and temporary? Steady as she goes at the Fed? There is no alternative?

Well - perhaps; most likely yes; and probably. That’s what head-scratching bond fund managers concede.

But even so, it rankles with many investors seeking a better fundamental explanation.

Olivier Marciot, portfolio manager at Swiss-based Unigestion, reckons estimates of U.S. growth, inflation and term premia capturing other uncertainties over time put ‘fair value’ for 10-year Treasury yields as high as 3.6% - more than a percentage point above current levels.

“Yields only obey the central banks,” he said, laying the blame squarely on the Fed.

With its $80 billion a month of Treasury purchases likely to persist through this year at least - and with two-thirds of global fund managers polled by Bank of America already expecting a tapering signal by September - you can see why it’s not a terribly fruitful battle for speculators to fight just yet.

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The BoA survey also had “Short U.S. Treasuries” as the fifth most crowded trade on the planet.

That said, JPMorgan are flatly dismissive of the counter-intuitive price action and urged clients this week: “Do not read too much into this month’s bond rally.”

It reckoned it was skewed by volatility-sensitive investors and speculative positioning, and offered opportunities to reduce ‘duration’ in core markets.

In what he calls a “surprising second wave of global liquidity,” Citi strategist Matt King has for months suspected some suppression of yields from the more than $1 trillion rundown of Treasury’s extraordinary $1.6 trillion General Account at the Fed between January and August’s Federal debt ceiling deadline.

That TGA rundown has flooded money markets with U.S. bank reserves, starved them of new Treasury bill sales, and pinned short rates to zero in the process - pushing some money, many suspect, at least further out the curve.

But this will fade as an issue through the second half of the year, King reckons.

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FOREIGN OVERSPILL?

But another finger repeatedly points to foreign demand for one of the few available ‘safe’ government assets not already hoovered up by the central banks of the world’s main G4 reserve currencies - dollar, euro, Japanese yen and sterling.

Currency hedge fund manager Stephen Jen at EurizonSLJ says the scale of bond-buying by the European Central Bank, Bank of Japan and Bank of England relative to underlying fiscal deficits - 161%, 110% and 129% respectively - means all three are effectively taking more bonds out of the market than their governments sell.

That shrinks amounts available for private investors needing safe assets in the main reserve currencies. But, because the Fed is still buying just 37% of U.S. deficits, the share of Treasuries in a notional global “free float” bond index is as high as 60% - more than twice that of 10 years ago.

The confluence of last week’s rally in Treasuries with a doubling down of the ECB on a faster pace of its pandemic-related bond buying - and also high foreign demand for 30-year Treasuries at Thursday’s auction - points in that direction.

Dollar hedging costs for euro and yen based investors are also attractive at the moment - adding to the lure of nominal 10-year Treasury yield premia over Japanese and German equivalents of between 145 and 175 basis points.

Jen says it is hard to pin all this down to last week’s price moves per se, but structurally there was a real issue here.

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“The whole world is running out of sovereign bonds to buy, especially sovereign bonds issued by a reserve currency-issuing country that carry meaningful interest rate return,” he said.

A Federal Reserve Board paper last year estimated the global accumulation of international reserves in sovereign safe assets since the 1990s - the so-called ‘global savings glut’ - has lowered the net supply of these assets and reduced neutral rates by up to 50 basis points.

Others acknowledge but downplay the foreign overspill into Treasuries as a dominant factor.

Mike Contopoulos, fixed income director at Richard Bernstein Advisors, told Reuters Global Markets Forum this week that there’s “some truth” to the strong overseas demand story and FX-hedged pull - but he reckons that foreign base typically can’t be relied upon over time, especially if the Fed were to taper.

On that score, Treasury data shows that - Fed aside - it’s Americans who have actually increased holdings of Treasuries over recent years - with pension funds to the fore. By the end of Q1, some 44% of Federal debt was held by domestic private investors - up 8 percentage points in just 5 years.

And like many markets, passive investing is a massive driver too. Lipper data shows U.S.-registered exchange traded funds in all taxable bonds more than doubled assets under management in that same five-year period, with Treasury ETFs alone holding almost quarter of a trillion dollars.

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