Elasticity of Yield Demand

Summary: There are many buyers of government bonds, ranging from big central banks, pensions, insurance companies, regular banks and investors (like you and me). The proportions of these cohorts change over time for many reasons. Today, we believe the groups whose demand is more sensitive to different yields have a larger representation. This could limit how far yields could come down, even in a recession, as lower yields may see many buyers stop or slow buying. We believe the overall elasticity of yield demand has risen.

Bond yields have certainly moved lower during the past month or two. Early May saw the 10-year U.S. Treasury yield around 4.75%, down to 3.9% as of mid-August. The drop in yields can be attributed to a couple of key factors: softening economic growth and calming inflation. The same trajectory has been evident with Canadian bond yields. Nothing like a little more recession talk to get yields to fall.

The big question is: How will low yields go? Naturally, a lot depends on the data, from no landing to soft landing or hard landing. While we all have our views, the economy's path is somewhat uncertain. But there is something we do know that may limit how far yields fall even if the data gets a lot worse – who the buyers of bonds are today and their motivation.

First, let's talk supply. There is A LOT! U.S. Treasury bonds issuance runs about $300 billion monthly and T-bills at about $1.5 trillion. Of course, a lot of this issuance is simply previous notes maturing and, in most cases, investors rolling the proceeds into the next issue. But you have to acknowledge the issuance of Treasuries spiked higher during a pandemic, and more recently, T-bills have moved materially higher. It is the size of the deficit that drives bond issuance above simply rolling maturities. The U.S. deficit is forecast to rise from $1.9T in 2024 to $1.94T in 2025 before dropping a bit and then moving a lot higher past 2028. I'm sure we can all agree that there will be no shortage of bonds/bills in the foreseeable future.

Now to the demand side and this is where things get really interesting. There are many holders or buyers of Treasuries, including households/hedge funds, pensions, insurance companies, the Fed, banks, foreigners, money market funds, and mutual funds. Some of these buyers are sensitive (elastic) to different bond yields, and some are not (inelastic).

Inelastic demand for yield

For pension and insurance companies, it is more about asset/liability matching than the specific yield available in the market. They have a relatively inelastic demand for yield. For the Fed, QE or QT has never been about buying or selling bonds because of the current yield available. It is completely inelastic. Banks buy treasuries often when they have excess capital and not enough demand for lending, not really caring about the level of yield.

Foreign central banks are an interesting one. The conspiracy folks say other global central banks are trying to diversify away from holding U.S. treasuries for political reasons. But most of these holdings are the result of global trade. Exporter sends stuff to that hungry U.S. consumer and receives USD back. So they exchange for their local currency at their private bank now that private banks have USD. They end up exchanging up the line to the central bank of the country, which then could sell or simply hold the USD. And holding the USD means buying and holding Treasuries.

Maybe they want to diversify reserves for political reasons. Or trade flows have gradually adjusted to tariffs and other factors, causing less direct exports to the U.S. In May 2018, China exported $52 billion of goods to the U.S.; in 2024, the average has been around $30 billion. When they buy Treasuries, they do not care about the level of yield. Their demand, too, is inelastic to yields; now, they are clearly a smaller buyer.

Elastic demand for yield

Households, money market funds, mutual funds, hedge funds, these are the groups that are very interested in what the current yield is. Me, you, clients, investors of all sorts have been attracted of late to investing in bonds, HISAs, money market, etc. because the yield available today is higher than it has been in many years. And why not. If your bonds can provide a 5-6% return for your portfolio, then you only need a bit more from equities to reach that 6-8% return baked into many financial plans. Or if cash can provide 4-5%, that is much more than near zero. Hence why the small trickle into cash products has ballooned to a raging river.

Inelastic demand for yield: pensions, insurance companies, the Fed, banks, foreign central banks.

Elastic demand for yield: households/hedge funds, foreigners, money market funds, mutual funds.

Why should we care as long as someone keeps buying the bonds to keep the government doing what it does? If yields fall, say from 4% to 3.5%, some of those elastic buyers may decide that just isn’t attractive enough. Or what happens if we reach 3% or 2.5%? Because more of the current bond buyers are more sensitive to yields, even slowing economic growth may not push yields as far down as in the past because the lower yields go, the more buyers start to balk.

Yields on cash have not come down yet in the U.S., as the Fed has not started to cut. But it is likely coming rather soon. Perhaps that has even been enough. Flows into money market funds have slowed, still positive mind you, but the raging river of inflows has become more of a gentle river. And with that drop in bond yields over the past few months, the inflows to bond funds and ETFs have slowed rather quickly.

Final Thoughts

A higher proportion of bond/bill buyers having a higher elasticity of yield demand may result in a shortage of buyers should bond/bill yields fall too far. This may dampen how low yields go and also limit how high they could go, as higher yields would attract more buyers. Overall, greater elasticity of demand for yield may very well dampen the volatility of yield (and the price, of course), keeping yields more rangebound than before.

— Craig Basinger is the Chief Market Strategist at Purpose Investments

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Sources: Charts are sourced to Bloomberg L. P.

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