Who will buy bonds when the Fed doesn’t?

Deutsche  has a new note this morning asking this question and the answer is discomforting:

Fed policy/change in fixed income flows could be key driver for bank stocks
While the timing is uncertain, most expect the Fed to slow its bond purchase program soon (i.e. taper) and will likely eventually stop it altogether. In addition, fixed income flows have turned negative and seem unlikely to return to the robust levels seen in recent years anytime soon.

Benefits of $800b/year of Fed buying/fixed income flows going away
Since QE3 began a little over a year ago, the Fed has added ~$1 trillion to its balance sheet and $3 trillion since late 2008. In addition, flows into fixed income assets have been strong (at least until about 6 months ago), totaling $900b since late 2008. Combined, Fed purchases and investor flows have averaged $800b per year since late 2008. This has likely been a meaningful positive driver to worldwide credit and equity markets and the US banks.

Near term impact of Fed taper seems likely to be negative
In the near term, the impact to markets and bank stocks is hard to predict and will likely be very dependent on macro data and the outlook for corporate earnings. On the one hand, if economic growth accelerates to the 3% consensus level in 2014 (from ~2% in 2013), additional P/E multiple expansion for banks (and the overall market) seems likely given rates remain low on an absolute basis, inflation is low and P/E multiples aren’t stretched (although are in line with historical levels). On the other hand, we worry about the potential combination of widening of credit spreads and rising interest rates; and the impact these may have on cost of funding, certain industries that are rate sensitive (like housing, FICC trading) and certain emerging markets.

Who will buy when the Fed isn’t
Banks are unlikely to be big buyers given securities levels are already above average and investment banks remain under pressure to further de-leverage. This leave investors, foreign gov’t, pensions & insurance cos. However, it’s not clear if this will be enough to absorb $0.5-1.0t/yr of extra supply vs. recent yrs.

My view is that it is pretty obvious that nobody will be able to fill the hole and as such yields will rise. Here’s Deutsche’s annotated chart of the ten year bond yield:



The only period where markets did not have support  from QE for any period was between late 2009 and mid 2010. That’s my benchmark for where yields will go as taper starts. 4% on the 10 year and 4.5-5% for the 30 year.

I retain my doubts that the US economy can take it.

Houses and Holes
Latest posts by Houses and Holes (see all)


  1. Right, so banks are never going to be the ones to buy the bonds. They mostly just act as intermediaries.

    The Feds research shows that the vast majority of its purchases are from the household sector (read: hedge funds) via primary dealers as intermediaries.

    These traders are the same ones who will find bonds attractive when the fed stops expanding its balance sheet at the expense of equities.

    When the fed stops buying, they will stop selling to the fed and start buying again in anticipation of the next round of QE. Same as every QE program so far – wish people would stop assuming there will be a structural change in the market when QE 3 ends, it will be the same result… lower yields, falling equities.

      • This is probably my favourite blog so I’m going to stop here and avoid starting an argument.

        I agree with almost everything macrobusiness, but not this. So I guess agree to disagree and time will tell.

      • We don’t disagree. Yields are rising right now on taper. I reckon they’ll get as high 4.50 on the thirty year and then start falling in anticipation of renewed QE, just as do.

        And I’d never argue with anyone here except flawse.

      • There’s an old saying – when you owe the bank a $million you have a problem, when you owe the bank $100m the bank has a problem. With the effective transfer of private debt to the public purse, combined with QE to bail out the banks, by buying their toxic assets like MBS’s .
        The quid pro is that the banks have to buy government bonds with very low coupon rates that will make government interest payments possible indefinitely – a circular Ponzi Scheme ?
        Governments have too much debt and hence we have a problem !
        Problem is, if QE ceases, then interest rates will rise, making government balance sheets implode. QE in the IOUSA underwrites interest rates indirectly in Japan and Europe. The tenuous state of the FPIIGS, would be destroyed overnight if interest rates move up.
        All questions of the deleterious effects of QE will have to take second place to the need to keep interest rates low for governments – or else governments will have only one choice – revolution or debt defaults – followed by the second great depression and then WW3 ?
        Cheers GBB.

  2. How will the US Treasury be able to afford the higher interest rates when it already has to borrow to pay the interest on its debt?

    What happens when foreign central banks, who own US$5,652.9 Trillion of US Treasuries, find out that the Fed won’t be able to taper?

    What happens when, on tapering, everybody realises that the bonds they already hold are worth a lot less because of the new higher interest rate regime?

    How on earth is the US Federal Reserve ever going to exit when it has assets of US$3.9Trillion and capital of only US$55Billion…it would be insolvent because it’s mortgage backed securities ( bought at face value ) would be worth half what they paid for them, and the bonds wouldn’t take long to chalk up US$55Billion in losses?

    Many questions…no taper possible.

    • http://www.zerohedge.com/news/2013-02-23/when-fed-has-print-money-just-print-money

      “[O]nce it becomes public knowledge that the Fed itself is broke in all but one technicality, and the resolution to said technicality is to go fully Weimar retard, the only hope the Fed will have to keep demand for dollars is if it gets caught in a closed loop of hiking rates ever higher just so banks keep onboarding reserves allowing the Fed to preserve the myth it is solvent, in the process pushing its NIM even lower, and needing to create even more “new reserves”, rinsing and repeating.

      Or, said otherwise, print more money just to be allowed to print more money.

  3. When it comes to taper I always think of

    1. A small or very slender candle.
    2. A long wax-coated wick used to light candles or gas lamps.

    Lighting fancy candles was one of the more interesting tasks of an altar boy (stop snickering).

    Thus when the Fed talks about tapering it always sounds like they are about to light something – a fuse perhaps.

    While the Fed engages in taper caper hi-jinx I am more interested in how quickly the Chinese advance adjustments to the operations of their capital markets.

    My feeling / vibe is that the Chinese government is keen to buy an increasing stash of anything that is not marked ÚS Treasury. Slowly of course, nothing to wake the patient.

    It probably doesn’t mind too much that a lot of Chinese are out selling Yuan for other currencies to buy houses and anything that is not nailed down overseas and the capital market changes will be focused mostly on facilitating that.

    Of course the Chinese will talk about the changes being to allow more investment in China and a bunch of westerns will start rubbing their paws together but whatever investment they allow will be closely regulated so the motherland captures a large chunk of the upside.

    And of course down in the dim hobbit world called Oz we are just excited that some big fancy overseas person thinks we are open for business and are interested in buying some more of our dwindling supply of hard assets or buying some more of our IOUs that we sell to re-engineer at great cost 19th century inner city slum accommodation.

  4. The Fed will fund (and then buy if needed to return liquidity to the primary dealers) the buying of bonds until bonds don’t need to be sold.

    It’s the “social contract” between the Fed and the Government.

  5. Yes it’s going to be the show of the century – To what extent the US housing market, the USD, US/global bond yields and US/global equities all wiggle and jiggle around when the Fed finally and officially says,”we are going to start tapering”.

    • As I posted elsewhere the Fed taper might sound like

      Go!…Whoo stop!…No Go!….Whoops s..t!Stop Stop!…No Go! Go! Go! …bloody hell hoocoodanode? STOP! FFS STOP…NO GOOOOOOOO!…Oh F..k!

  6. hubris_and_hyperbole

    The primary dealers always buys the bonds when they are issued — they are required to. And the coverage for these auctions is and has always been very high.

    The Fed buys on secondary markets — by law it cannot buy on primary markets. If and when the Fed disappears as a buyer on secondary markets pundits like Deutsche will be shown to be wrong about their hand wringing …AGAIN