The Big Idea

Buyers, sellers in Treasury, MBS and corporate debt

Steven Abrahams | June 23, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Every major US market relies on just a few types of investors for support. The US Treasury market relies on foreign investors and the Fed. The MBS market on the Fed and banks. And the credit markets on foreign private portfolios, life insurers and mutual funds. That means the ebbs and flows of these balance sheets matter. And with the Fed and banks now at the beck and call of monetary policy and bank regulation, the credit markets may be the healthiest of them all.

US Treasury debt

The US Treasury market continues to rely on important support from foreign investors. Non-US portfolios started the year holding 29.7% of outstanding marketable Treasury debt and finished the first quarter 0.2% higher. Both foreign central banks and private portfolios added. And of the five largest holders—Japan, China, the UK, Belgium and Luxembourg—only Belgium’s holdings slipped. With the US continuing to run some of the largest current account deficits in its history, foreign investors should continue to have a heavy supply of dollars to invest, a lot of that bound for Treasury debt yielding far more than most benchmark global yield curves other than the UK.

Exhibit 1: Foreign portfolios and the Fed dominate the Treasury market

Source: Federal Reserve, Financial Accounts of the United States through 1Q2023, Santander US Capital Markets

Foreign support may prove especially important with the steady exit of the Federal Reserve. The Fed started the year owning 20.5% of the market and ended the first quarter down 0.9%. Fed holdings probably will keep falling for several years even while the Fed eventually eases and brings financial conditions back to neutral.

Of the other major holders of Treasury debt—Federal retirement accounts, households, state and local governments, mutual funds, US banks and money market funds—only the later two have clear incentives to add Treasury exposure. Likely changes in bank regulations should give banks with assets between $100 billion and $250 billion new incentives to hold Treasury debt to meet liquidity requirements. And money market funds should have a good bid for Treasury bills if the funds continue to attract cash that might normally sit on bank balance sheets.

Agency debt and MBS

The market for agency MBS continues to struggle with falling demand from its biggest investors and steady supply. US banks started this year with a 27% share of outstanding agency obligations—almost entirely in MBS—and finished March down 2% (Exhibit 2). The Federal Reserve started with a 21% share—also almost entirely in MBS—and finished down 1%. And the share of these two big investors should keep heading south. The Fed’s weekly H.8 snapshot of bank balance sheets shows agency MBS holdings dropping into June, and the Fed continues to let its own holdings roll off. The falling demand comes as net new supply of agency MBS rises so far this year by an average of nearly $20 billion a month, with that number likely to rise through the heavy summer home sales season.

Exhibit 2: Banks and the Fed, the biggest agency holders, are trimming exposure

Source: Federal Reserve, Financial Accounts of the United States through 1Q2023, Santander US Capital Markets

Other big investors show mixed signs of stepping up. The rest of the world, made up of largely of foreign central banks, commercial banks and insurers, held a steady 12% share of agency obligations through the first quarter. Households also held a 12% share, but the Fed calculates household balances simply by subtracting all other known holdings from total outstanding debt, leaving household share subject to major revisions and hard to interpret. Money market funds increased their share of agency obligations—almost entirely in agency discount notes—from 5% to 7%. And mutual funds held a steady 5% share.

The Financial Accounts do not reflect the FDIC’s ongoing sales of $59.5 billion in agency pass-throughs, $22.7 billion in CMOs and $14.0 billion of agency CMBS acquired after the collapse of Silicon Valley Bank (SVB) and Signature Bank. Those sales started in April and helped widen MBS spreads. The wider spreads have pulled in good buying from mutual funds and REITs, so the share of those buyers will likely move up when numbers for the second quarter get reported.

The biggest holders look set to keep heading for the exits. Likely changes in bank regulations after the SVB and Signature Bank collapse have clearly put a hold on bank appetite for the duration and negative convexity of MBS and stand to keep it lower in the future. And the Fed seems committed to reducing its MBS exposure. The recent return of MBS spreads to levels before the bank collapse likely means spreads will have to go wider before mutual funds and REITs come back with enthusiasm (Exhibit 3).

Exhibit 3: MBS option-adjusted spreads have tightened back to pre-SVB levels

Source: Bloomberg, Santander US Capital Markets

Corporate debt, and private MBS and ABS

The markets for corporate debt along with private MBS, CMBS and ABS have the healthiest mix of investors among the major sectors. Foreign investors along with life insurers and mutual funds hold a cumulative 60% share of these markets, mostly in traditional corporate debt (Exhibit 4). As noted for the Treasury market, historical US current account deficits continue to put dollars in foreign pockets, and many foreign private portfolios allocate to US corporate debt. Demand from US life insurers generally tracks US GDP, and although GDP looks set to slow, it still has good odds of staying positive. And mutual funds this year have drawn steady inflows, of which roughly 28% gets allocated to corporate debt.

Exhibit 4: Foreign portfolios, life insurers and mutual funds dominate credit

Note: The Financial Accounts includes corporate debt, private MBS and ABS under the same category. Here MBS includes ABS.
Source: Federal Reserve, Financial Accounts of the United States through 1Q2023, Santander US Capital Markets

Perhaps just as important as reliable demand from foreign portfolios, life insurers and mutual funds, credit market exposure to banks and the Fed is limited to around 6%, making the sector less vulnerable to changes in regulation or policy. While the Fed and banks both trimmed exposure to Treasury debt and MBS in the first quarter, their limited role meant that no other investors had to absorb excess supply. The market share of nearly every credit investor stayed relatively constant through the first quarter.

Corporate spreads over the next few quarters will likely adjust to changing expectations for recession, but the sector has less buyer concentration and should continue to adjust smoothly. With agency MBS option-adjusted spreads at current levels, corporate debt looks like slightly better relative value (Exhibit 5).

Exhibit 5: IG corporate spreads have tightened with US debt ceiling resolution

Note: Cash IG corporate spreads.
Source: Bloomberg, Santander US Capital Markets

* * *

The view in rates

OIS forward rates now put fed funds near 5.40% from September through December. But the same forwards also anticipate 140 bp of cuts in 2024. This is just the latest version of market pricing for a terminal fed funds rate, the length of the Fed pause and the pace of eventual cuts. The stickiness of core inflation—it has been running steadily near 5% for the last few months—suggests cuts in 2024 look premature. The Fed looks more likely to hold fed funds at a terminal rate well into 2024, something that would actually tighten financial conditions if nominal rates stayed constant and core inflation dropped. Under those circumstances, real rates would rise. That is likely the Fed plan.

Other key rate levels:

Fed RRP balances closed Friday at $1.97 trillion, the lowest level since May 2022. With the Treasury replenishing its cash balances after the resolution of the debt ceiling, the T-bill market is likely drawing cash away from the RRP.
Settings on 3-month LIBOR have closed Friday at 554 bp, unchanged from two weeks ago. LIBOR goes away after this month. Setting on 3-month term SOFR closed Friday at 524 bp, also unchanged from two weeks ago. The gap between LIBOR and SOFR is wider than the recommended ARRC spread of 26.16 bp
Further out the curve, the 2-year note traded Friday at 4.74%. With the Fed likely to hike again and hold fed funds around 5.375% into next year, fair value on the 2-year note is slightly above current yields. The 10-year note closed at 3.74%, unchanged over the last two weeks. With inflation likely to drift down and growth likely to slow, fair value on the 10-year note is lower than current yields.
The Treasury yield curve traded Friday afternoon with 2s10s at -101, flatter by 16 bp over the last two weeks. Expect 2s10s to flatten further. The 5s30s traded Friday morning at -18 bp, 15 bp flatter over the last two weeks.
Breakeven 10-year inflation finished the week at 221 bp, unchanged over the last two weeks. The 10-year real rate finished the week at 153 bp, down by 2 bp in the last two weeks.

The view in spreads

With the debt ceiling resolved and the June FOMC done, volatility has continued to drop. That should help nominal spreads in MBS and credit. The Bloomberg investment grade cash corporate bond index OAS closed Friday at 156 bp, tighter by 7 bp in the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 161 bp, down 3 bp in the last two weeks. Par 30-year MBS TOAS closed Thursday at 50 bp, down 1 bp in two weeks.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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