Last day of Fed Treasury purchases: do as the Fed does?

Today, the Fed is completing its 300bn Treasury purchase programme. In turn, the Fed's demand for USTs is evaporating. Should one behave as the Fed does and stop buying govies to move to a short duration position? I do not think so! While tactically, I have been proposing a neutral stance since Oct 12, I doubt that the end of the buying programme will have a significant effect on market valuations and see no convincing reason to change my strategic government bond-bullish stance.

Maturity distribution of Fed Treasury Purchase Programme (in bn USD)

Source: Atlanta Federal Reserve, ResearchAhead

Today, the US Fed will finish its 300bn USD Treasury purchase programme via the buying of USD 2bn in 4-7yr UST. The chart above shows the maturity distribution of the purchased Treasuries so far. The 4-7yr and 7-10yr part of the curve have seen the biggest demand where almost half the buying has been taking place. The above 10y sector has seen a relatively smaller share with a total of USD41bn being purchased. Additionally, TIPS only saw USD4.5bn in buying. Given that this demand is falling away some market participants have been looking for a more challenging environment for UST. I personally, doubt that it will have significant medium-term effects on UST valuations. I am convinced that a) macro-economic developments play a much more important role and b) demand by households and banks/institutional investors is likely to increase.
The medium-term macro-economic outlook is still bond market supportive. My base case remains for an extended period of on average subdued real growth amid the ongoing private sector deleveraging and unwinding of macro-economic imbalances which promises to take several years. Real trend growth should be markedly below the experience of the past decade. Furthermore, current growth is still far away from being self-sustainable. Rather it remains dependent on the life support provided by accommodative monetary and fiscal policy. While this has helped to move back into a positive growth environment for Q3, one should not forget that the effects of the fiscal measures on growth evaporates not once the fiscal stimulus is taken away but already much sooner when the fiscal stimulus has hit its maximum level as it is the change in the size of the fiscal stimulus that is important for growth. Once the maximum level of fiscal stimulus has been reached, the effect on growth drops to 0! So overall, I expect real growth to fluctuate in between roughly -1% to +4% per quarter for several years with a low average of around 2%. Moreover and as I have written frequently, inflation pressures should remain subdued for a prolonged period of time amid ongoing credit destruction and significant excess capacity. In turn, yearly nominal growth rates are likely to average close to 3-3.5% for quite some time which should keep nominal bond yields at historically low levels for the next years.

Medium-term nominal growth is the key driver for nominal bond yields

Source: Bloomberg, ResearchAhead

With respect to demand for US Treasuries, I think that private households as well as institutional investors are likely to increase their appetite despite the low yields. First, households need to restore their balance sheets and reduce indebtedness. This should go hand in hand with a higher savings ratio and should also see an increase in investable funds. In light of the difficult economic environment and the disappointing experience with equity investments I expect the demand for the safe-haven of government bonds to increase. Also important institutional investors should see increasing pressures to change their structural asset allocation. Pension funds in a host of countries including the US have had large shares of equity investments. However, as equity performance over the past decade has been poor while the rates used to discount the future pension liabilities have decreased, there is an increasing underfunding problematic for these future pension liabilities. This reduces the risk-taking capabilities of the pension funds - and similarily for life insurers - and in turn is likely to force them to adapt a higher fixed income share in their portfolios. Finally, banks' balance sheets remain in a difficult position and coupled with the subdued economic outlook, the ability and the willingness to lend is low. In turn, banks are more likely to use their excess reserves to conduct carry strategies via UST than to increase their lending actitivities.

Therefore, fundamentally as well as from the demand side I do not see a good enough reason to change my bond bullish strategic stance. Stick to strategic longs in the US and the Eurozone!