Running for the Exits
Hedge funds are dumping Treasury bonds. Do they know something?


Jim Lacey

The wisest and most successful bond investor of all time, Bill Gross, has dumped his bond fund’s $150 billion investment in U.S. bonds. One should not ignore the importance of this event. The largest bond fund in America no longer believes that Treasury bonds are a good investment. Moreover, Gross is not alone. Blackrock, the world’s largest money manager, is now underweighting Treasuries overall and reducing the duration of the bonds it still holds. That means they are dumping their long-term bonds, which are the most sensitive to interest-rate changes, in favor of Treasury instruments that mature in a year or less. Other bond funds, such as the $20 billion Loomis Sayles funds, are also forgoing Treasuries in favor of high-yield corporate bonds. Virtually everywhere you look, from great investors such as Warren Buffett to insurance companies such as Allstate, everyone is dumping their long-term U.S. debt and either buying debt that matures in less than a year or moving their money elsewhere.

So who is still buying U.S. debt? According to Bill Gross, the “old reliables” — China, Japan, and OPEC — are still in the market for 30 percent of all new debt. The rest, however, is being purchased by the Federal Reserve. There is no one in else in the market. For the first time ever, Americans are refusing to purchase their own country’s debt.

Gross estimates that the “old reliables” are still good for $500 billion a year in purchases, and will be for some time in the future. This is pretty much the amount they’ve had to buy in the past to rebalance capital flows distorted by the U.S. trade deficit. Gross, however, may be wrong this time. Japan, needing to finance its reconstruction, is much likelier to be a net seller of U.S. debt, while China’s economy is slowing and actually ran a trade deficit in the last quarter. That leaves only one buyer of consequence — the Federal Reserve.

Researchers at Gross’s firm, PIMCO, estimate that in the last quarter, the Fed purchased 70 percent of all new Treasury debt. This is a disaster in the making. By printing new money to buy debt, the Fed is both holding interest rates artificially low and flooding the world with dollars. Fed purchases have lowered rates to the point where there was no room for further decreases. With no more upside potential to holding debt, investors are fleeing on the assumption that the Fed will soon exit the market, causing rates to rise dramatically. Such a rate rise lowers the value of all current U.S. debt: Who will pay $1,000 for a bond paying 3 percent when she can get one paying 5 percent? Anyone who wants to sell a $1,000 bond they already own is therefore forced to lower the price if they wish to attract buyers. No one holding any of the almost $10 trillion in U.S. public debt is getting much sleep these days.

When the Fed’s $600 billion QE2 buying spree ends, there will not be enough buyers left to purchase the $1.4 trillion in debt the administration has built into this year’s budget, at least not at current interest rates. Gross believes interest rates have to rise approximately 1.5 percent (150 basis points) to attract sufficient buyers. This may be optimistic.

The Fed is not only looking to stop buying new debt, it also wants to get rid of the nearly $1.3 trillion currently on its balance sheet. Absorbing $1.4 trillion in new debt, rolling over maturing debt, and simultaneously purchasing debt the Fed bought during its quantitative-easing forays is a lot to ask of the market.