Who Buys Treasuries Once the Fed Leaves Town?

"Investors should view June 30th, 2011 ... like June 6th, 1944 (D-Day -- a day fraught with hope for victory, but fueled with immediate uncertainty and fear as to what would happen in the short term)."

It'd be easy to brush off that kind of talk as rambling hyperbole if it came from almost anyone other than the man who said it -- Bill Gross, the head of PIMCO, the world's largest bond manager. He knows what he's talking about, and he puts his money where his mouth is.

June 30 is when the Federal Reserve is set to finish its $600 billion campaign of buying U.S. Treasury bonds. The program's known as QE2, for the second round of quantitative easing. What happens when it ends is anyone's guess. It's always that way with this stuff. We do, however, know what happened when the Fed's first bond-buying program, QE1, ended last year. And it wasn't pretty.

Gross first puts the size of QE2 in perspective. The Fed has bought roughly 70% of the Treasuries issued by the government over the past several months. The Fed buys Treasuries even in normal times, but the weight it's throwing around today is simply awesome:

Who buys Treasuries?

 

Source: PIMCO.

Understanding this chart is key to piecing together the QE programs' impact. One of the funny things about both QE programs is how counterintuitive the results have been. The Fed's goal in buying Treasuries is to push bond yields down, which should spur economic growth. It may have achieved growth, but bond yields have done just the opposite of what was expected. After the Fed stopped buying bonds when QE1 ended last spring, yields plunged. When it started the printing presses back up for QE2 last summer, yields rose.

None of that should make sense unless you realize the importance of this chart. It's pretty simple: The Fed's extra bond buying will push down yields only if other buyers -- either foreign sovereigns, or private investors like hedge funds, pension funds, and banks like Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) -- continue buying Treasuries at their normal rates. But if PIMCO's data are accurate, that hasn't been the case. Private buyers have all but been driven out of the market, leaving the Fed and foreign buyers to soak up supply.

Factor that in, and rising yields in the face of massive Fed buying could actually make sense. If the Fed's $600 billion QE2 program drove, say, $1 trillion worth of private buyers out of the Treasury market, rising yields is exactly what you'd expect. And that looks about like what happened.

But where did that private money go? Money that used to chase Treasuries began chasing something else. Stocks. Gold. Oil. Junk bonds. You name it. Nearly everything expect Treasuries has been rising, or did rise, during QE1 and QE2. Assuming private money was chased out of the Treasury market, that's exactly what you'd expect to happen. The cash has to go somewhere.

So what happens when QE2 ends in June? Again, who knows. Weird things happen. But I don't think rising interest rates is the biggest risk, as so many assume. I don't think you have to worry about who's going to buy Treasuries. Someone will. Private buyers will line up for them in the Fed's absence. It's what they did after QE1. They may form such a long line that yields actually fall.

The real risk is what happens to other assets when that happens. Private money that over the past six months chased stocks and commodities might run to its old home, the Treasury market. If it does, you can guess what happens. Just remember what markets did last summer. It isn't an enjoyable experience.

The silver lining is that all of this is just short-term rattling noise. Whatever the Fed does, or doesn't do, has no impact on the long-term value of businesses. Good, high-quality companies with strong brands and high returns on capital, like Coca-Cola (NYSE: KO  ) and Procter & Gamble (NYSE: PG  ) , shouldn't care about QE1, 2, or 7. The price of their shares, though, probably will. It's what markets do. In the end, that's a good thing. It creates opportunity. Get ready for it. Should be fun.

Fool contributor Morgan Housel owns shares of Procter & Gamble and Bank of America preferred. Coca-Cola is a Motley Fool Inside Value recommendation. Coca-Cola and Procter & Gamble are Motley Fool Income Investor recommendations. The Fool owns shares of Bank of America and Coca-Cola. Through a separate Rising Star portfolio, the Fool is also short Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 11, 2011, at 6:16 PM, Borbality wrote:

    I'm hoping the market doesn't go haywire, but I would buy on the dip if it happens.

  • Report this Comment On March 12, 2011, at 10:44 PM, MrFearful wrote:

    Can anyone just put any link under any article here? That seems really foolish to me... It´s almost insulting.

  • Report this Comment On March 12, 2011, at 10:45 PM, MrFearful wrote:

    Cool... the stupid links have just disappeared. Nice work.

  • Report this Comment On March 13, 2011, at 12:54 PM, Nick2012 wrote:

    I am not sure what point you are trying to make. The stockmarket is a simple machine for discounting future expected cashflows from individual companies. It employs an interest rate, which is an aggregate of a risk free IR (say 10yr bonds) and a risk premium for the company.

    Now, if u are right and the Fed pulls out of the market, bonds will be bought, just as you state, but at higher interest rates, or lower prices, by the people the Fed squeezed out previously. The risk premium is also likely to rise. So, KO and PG will also be discounted by the exact same increased IR. Their price will fall, but not to return where it came from. It should just fall, period. Only if KO or PG were to increase turnover (or expectations of turnover) would the price go back up. And I cant see that happening in a market with a steep yield curve.

    Don't get me wrong, I am agreeing with you that when the Fed pulls out, all hell could brake loose. But it will NOT be a buying opportunity. Instead the ANTICIPATION of the Fed pulling out is a SELLING opportunity. But somehow I doubt it will be that simple. If stocks do not start declining BEFORE June, it will be a clear signal that the market expects a QE3, followed by a 4,5,6,7....and the market is usually right.

  • Report this Comment On March 13, 2011, at 3:14 PM, jimmy4040 wrote:

    The earthquake has been a game changer. Japan is the number three buyer of Treasuries after the Fed and China. They will be exiting that market at least temporarily. Look for talk to begin this week on an extension of QE2 or even a possible QE3, because we can't have the Fed and Japan drop out of the marketplace at the same time.

    Remember you heard it from me first!

  • Report this Comment On March 14, 2011, at 9:48 AM, lctycoon wrote:

    There should be a system in place where you have to post so many good comments before you can post a link to anything. That would get rid of a good deal of this spam.

    Hick, that sounds like the discounted cash flow model, WACC, and maybe even the EMH to me. In the short term, though... those things don't really hold. The main reason for that is that the vast majority of market trading is just that - trading by computers. The value of a company stays the same no matter what the stock price is. Sometimes though, the market overvalues stocks and sometimes it doesn't.

    The author is correct, if stocks fall after QE2 ends (which is definitely possible), it is a buying opportunity. You are also right in that selling into the anticipation of the fall could also be a selling opportunity. I fail to see any difference between the two... anytime stocks fall below their intrinsic value, it's a buying opportunity. The inverse is also true, anytime stocks climb above their intrinsic value, it's a selling opportunity.

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