Treasuries Slide Just Short-Term ‘Washout’ if History Holds

(Bloomberg) -- A looming liquidity squeeze in U.S. money markets may put the lid on the recent sell-off in Treasuries, overwhelming bullish sentiment from central bank stimulus and easing trade tensions.

History shows that episodes like the one now under way point to limited upside for bond yields, according to analysis by Oxford Economics. A slew of debt issuance will likely see the U.S. Treasury Department’s cash balances climb by about $200 billion -- “squeezing excess liquidity in funding markets,” analysts at the research group including Gaurav Saroliya wrote in a note Wednesday.

“Previous instances of such liquidity deterioration have often led to a rally in U.S. Treasuries, our heaviest government bond overweight, as risk sentiment typically deteriorates,” Saroliya and his colleagues wrote.

The team pointed to a rising premium on three-month forward-rate agreements compared with overnight indexed swaps, a gauge of strain in money markets, as evidence of deteriorating liquidity.

For now, Treasuries have been sliding -- with 10-year yields up about 30 basis points since the low on Sept. 3, to 1.72% -- amid a confluence of factors. The U.S. and China agreed to restart trade talks and undertook some goodwill gestures, risks around Brexit and Hong Kong have eased, and at least some economic data haven’t surprised on the downside.

“All these tantrum drivers are likely to be temporary,” according to Oxford Economics. They’ll be “enough to cause a short-term positioning wash-out” before demand for longer-duration Treasuries revives, the analysts wrote.

Fundamentally, their view is that China is unlikely to ramp up stimulus, while central banks in other countries undertake a “rather uncoordinated and piecemeal approach to policy easing.” That leaves little case for a sustained growth recovery or pick-up in inflation, in their view.

And meantime, the U.S. Treasury is going to be selling an estimated $814 billion in marketable securities from July to December -- in the process rebuilding its cash balances in the wake of politicians agreeing to boost the federal debt ceiling.

While greater debt issuance might logically lead to higher yields, Oxford Economics analysis focuses on how the boost in the Treasury’s cash will effectively squeeze bank reserves.

“This is likely to generate safe-haven demand,” Saroliya and his colleagues concluded.

To contact the reporter on this story: Christopher Anstey in Tokyo at canstey@bloomberg.net

To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Cormac Mullen, Joanna Ossinger

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