Treasury Market Drivers—Less Issuance, U.S. Dollar Strength and Increased Savings

Aside from the global market volatility that has been so prevalent this year, there are three fundamental factors we are watching that have the potential to drive the U.S. Treasury market in 2016. First, the U.S. federal budget deficit ended 2015 at 2.6% of gross domestic product, which is its lowest level since 2007. A smaller federal deficit is the result of strong tax revenue growth and a slower rate of government spending after the 2011 sequestration. Resilient domestic economic growth could support this trend. However, over the longer-term, non-discretionary spending for Medicare and Social Security are expected to increase as more people become eligible for these social benefits. Goldman Sachs estimates that the budget deficit could rise to 3.5% and 3.0% of GDP in 2016 and 2017, respectively. The second potential Treasury market driver getting attention is a rising U.S. Dollar and Chinese Yuan. The Yuan has a soft peg to the USD, so as the USD strengthens, the Yuan does, too. The strengthening Yuan has been blamed for contributing to the weakness in China’s export oriented economy. To mitigate the impact on exports and to accelerate economic growth, China is devaluing its currency by selling its foreign currency reserves. It could be argued that the sale of large quantities of U.S. Treasury holdings may overwhelm demand and cause the price of Treasuries to fall, though YTD there is no evidence of this, as rates have fallen materially in the first two weeks of trading. Bank of America Merrill Lynch estimates that China sold a record $510 billion in FX reserves last year, of which 57% were U.S. Treasuries. Barclays Research and U.S. Treasury data confirm (see table) China and foreign holders of Treasuries are net sellers, with foreign investor holdings falling from 30% in 2009 to 19% in 2015. The third potential driver of the Treasury market this year is the U.S. saver. Domestic investment or saving in U.S. Treasuries has exploded since 2009. Using the same Barclays Research, we see investment here at home grew from 16% to 44% in 2015. The 28% growth in domestic investment is partially due to stricter capital regulations on banks, which require them to hold more high quality liquid assets on their balance sheets, as well as falling household debt as a percent of personal income (the 5-year average dropped from 95.7% to 91.2% currently) and the personal saving rate increasing from 4.4% at the end of 2013 to 5.5% at the end of 2015. 

Sources: Wall Street Journal, Bank of America Merrill Lynch, Barclays, US Treasury and SNWAM Research