Bond demand exceeds supply for a decade

Reading time: 4 – 7 minutes

Over the decade, 1995-2004, the demand for US bonds of all types has surpassed new bond issues in eight of the last ten years. This is the reason that bond prices have held firm, even in 2003, when net new issues reached almost $1.8 trillion.

According the Federal Reserve Flow of Funds Accounts, six groups made up 90% of net bond buying over the decade:

Plotting supply and demand

The graph shows the breakdown of net bond buyers over the decade (the colored bars), against the supply of new bonds (the red line.)

Supply & Demand: US Bonds

As the graph indicates, only in 1998 and 2003 did bond supply catch up with demand, represented on the graph by the years in which the red buttons are at the top of the bars.

In most years, buyers had to go to the secondary market to get all the bonds they wanted.

The bars on the graph that extend below zero can be interpreted as bonds acquired in the secondary market. See Flow of Funds Accounts Tables: F 209, F 210, F 211, F 212.

A complicated market

Viewed in terms of Capital Flow Analysis, the bond market is more difficult to understand than the stock market which is driven primarily by corporate stock buybacks and tax-deferred investment in mutual funds.

In 2005, there have been four main sources of new bonds for the market:

1. Treasuries: Sold to cover Federal government deficit spending;
2. Agencies: Issued to finance the residential housing market;
3. Corporate and Foreign Bonds: Floated to finance private business and consumer spending.
4. Municipal Bonds: Underwritten to finance infrastructure projects of states and local governments.

Over the decade, 1995-2004, Treasuries accounted for 8.9% of new issues; corporate bonds were 44.7% of issues; agency securities totaled 39.5% of new bonds sold; and municipals accounted for 6.9%.

Fannie Mae's difficulties reduced bond supply

The shake-up at Fannie Mae in 2004, took a big chunk out of the supply of bonds — a gap that is unlikely to be filled in the short-term, although many mortgage-backed issues have migrated into asset-backed securities sponsored by Fannie Mae’s competitors.

As the US economy recovers, the need to issue Treasury bonds should continue to lessen, further reducing the supply of bonds.

On the demand side, steady buying pressure, accounting for about two-thirds of the market, has come from foreign investors, insurance companies, federal, state, and local governments, and banks and savings institutions — each acting for difference reasons.

Demand from the other major buyers, households and mutual funds, has been volatile, jumping in and out of the market in anticipation of a fall in bond prices or rise in equities (sometimes, mistakenly).

What to look out for

Without question, the most sensitive element in the bond market is the position of foreign investors that have accounted for one-third of demand over the decade, in a rising trend.

The US trade deficit creates demand for bonds

The motivation of these investors is primarily to safeguard dollars earned by exporting to the United States, reflected in a trade deficit that has grown steadily for more than a generation.

If the trade deficit were to go away suddenly, as some in Congress seem to advocate by proposals such as a penalty tariff on Chinese goods, this could cause a sharp drop in the demand for bonds, driving prices down and forcing interest rates up, leading to a crisis.

Barring some untoward action on the part of the US Congress, or a serious setback in the War on Terror (such as a nuclear attack on New York City), or a move by radical Islamists to price oil in euros rather than dollars, the trade deficit is likely to be sustained for at least a decade, providing essential support to the US bond market.

So, the most important areas to follow when predicting bond prices would seem to be the trade deficit and the War on Terror.