For fixed-income investors, low long-term bond yields have been a mystery.
With the Federal Reserve unwinding its historically aggressive easing program and expectations growing for economic growth as the year progresses, market pros have been expecting yields, particularly further out on the curve, to start swelling.
However, the 30-year bond yield is about half a percentage point lower than where it started 2014, and the yield curve, or spread between yields of varying maturities, actually has flattened.
David Yoo, the well-known forex and rates strategist at Bank of America Merrill Lynch, thinks he knows what's been driving the low yields: China.
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A national liquidity squeeze has pushed China into buying Treasurys at a time when most other investors are selling U.S. government debt, particularly of the longer duration, he said. Investors fear that once the Fed steps out of the game—it already has reduced its monthly purchases by $30 billion and likely will slash another $10 billion from that total this week—yields will have nowhere to go but up as prices fall.
China, though, finds itself in a liquidity squeeze as it seeks to slow down the flow of capital and stave off a feared credit bubble. As a result, Yoo said, it is parking money in bonds and keeping U.S. yields now.
In a note to clients, Yoo explained the dynamic:
We believe that US Treasury yields and the (U.S. dollar) have been depressed by two factors.
—The market is not pricing in sufficient weather payback after an extremely severe winter. With the consensus forecast for Q2 US GDP growth at just 3 percent, Wall Street is expecting the weakest bounce back after a severe winter in 50 years.
—Liquidity squeeze as the result of China's decision to rein in unsustainable credit growth has attracted increased capital inflows into China. This in turn had led to an acceleration in the pace of reserve accumulation. In our view, the recycling of these reserves into Treasuries might be reducing the sensitivity of US rates/(the U.S. dollar) to better US news lately.
For the moment, Yoo thinks it's a temporary phenomenon. After all, the market conditions are all in place for a turn in yields, even though expectations have proven wrong:
The unhappy reality for Treasury bears/(dollar) bulls (including us) this year is that if they were correct about the conditions for higher rates/higher (dollar) soon falling in place, they could not have been more wrong about the market outcome.
To be sure, China, the world's leading foreign holder of U.S. debt at $1.27 trillion, might not be the only explanation.
Recent reports off Fed data show that banks have increased their Treasury holdings after an aggressive year of selling. Pension funds, too, have increased their purchases.
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And global central banks, Yoo noted, may be increasing their holdings, though monthly Treasury data indicates this isn't the case, save for a $95 billion increase for Belgium that Yoo thinks may reflect Chinese buying.
However, none of those purchases seem to be in the amount that would hold the 30-year hold in check to the current extent.
Yoo noted that his view that the Chinese activity is temporary could be wrong, and if so that could pose some problems for investors.
The biggest risk to our view is the potential negative reaction of risky assets to continued Fed tapering and a slowdown in Chinese Treasury purchases. What worries us is the possibility that Chinese purchases have masked the impact of Fed tapering. This suggests that volatility is too low.