The rally in Treasuries, due primarily to a flight to quality by US investors, has masked a troubling trend: a retreat from Treasuries by foreign investors.
Today’s Bloomberg story quotes investors openly discussing their disenchantment with the dollar. This is more significant than it might appear.
First, this selling of Treasuries is almost certain to be due to foreign central banks moving away from the dollar. With the exception of Japan, where retail traders are particularly powerful, most of the foreign purchases of Treasuries are by central banks, China and the Gulf States in particular. Their purchases have been a big prop to the dollar, but even they have been quietly diversifying their portfolios (see here and here). But the fact that it is now being discussed openly may mean that the foreign central banks will feel it less necessary to do their selling gradually and quietly. That alone could lead to further repudiation of the dollar.
Second, this action by foreign investors constrains Bernanke’s options. Even if the thinks rate cuts are warranted, he dare not go to far because it will lead to dumping of the dollar.
Indeed, in a worse-case scenario, interest rate cuts by Bernanke could lead to a sufficiently large reduction of foreign purchases of financial assets so as to increase yields in the intermediate-to-long end of the yield curve enough to more than offset the impact of cuts on short-term rates.
Recall that the Fed’s interest rate rises were ineffectual, and the same can be true of rate reductions. As Harvard professor and president of Harvard Management Corporation Mohamed El-Erian observed:
Over the past two years, markets have developed powerful liquidity factories as more investors have embraced debt in an attempt to increase the impact of their investments. The process has been facilitated by stable global economic conditions, widespread use of derivatives and low borrowing costs. As overall market leverage has increased, the impact on markets has more than offset the US Federal Reserve’s 2004-2006 campaign of 17 successive interest rate increases.
A drop in the supply of foreign capital would greatly curtail the operation of these “liquidity factories” and neuter, perhaps even overwhelm, the effect of Fed actions.
Treasury investors basking in the biggest rally in four years have reason to fear for their profits: The largest owners of U.S. government debt are heading for the exit.
Two-year Treasuries returned 1.09 percent in August, the best monthly performance since 2003, according to indexes compiled by Merrill Lynch & Co. At the same time, holdings of U.S. bonds by governments and central banks at the Federal Reserve fell 3.8 percent, the steepest decline since 1992.
The dollar’s slump to a 15-year low against six of its most actively traded peers is turning the gains into losses for international bondholders, prompting China, Japan and Taiwan to sell. Overseas investors own more than half of the $4.4 trillion in marketable U.S. government debt outstanding, up from a third in 2001, according to data compiled by the Treasury Department.
“The support that Asia has shown in buying U.S. Treasuries has been a major supporter of keeping long-term interest rates lower than where they probably would be,” said Gary Pollack, who oversees $12 billion as head of fixed-income trading in New York at the private wealth management unit of Deutsche Bank AG, Germany’s biggest bank. “This could put some upward pressure on yields in the United States.”
U.S. long-term interest rates would be about 90 basis points, or 0.90 percentage point, higher without foreign government and central bank buyers, according to a 2006 study for the Fed by Professors Francis and Veronica Warnock at the University of Virginia in Charlottesville….
The dollar fell 8 percent against the yen in the past two months, causing losses for Japanese funds that own Treasuries. The New York Board of Trade’s dollar index, which tracks the currency against the yen, euro, pound, Canadian dollar, Swedish krona and Swiss franc, fell as low as 79.841 on Sept. 7 from last month’s high of 82.132 on Aug. 16.
Kokusai Global Sovereign Open, the world’s second-biggest managed bond fund after the Pimco Total Return Fund, is buying yen-denominated debt.
“The dollar may weaken for a while,” said Masataka Horii, one of three managers for Kokusai Global in Tokyo, which has $46.6 billion in assets. Kokusai reduced dollar-denominated debt to 24 percent of holdings in August from 25 percent. “The U.S. will probably reduce its policy rate. That will favor the euro.”
Interest-rate futures show traders are betting with 100 percent certainty the Fed will trim its benchmark by at least a quarter percentage point to 5 percent at its meeting Sept. 18.
Former Fed Chairman Alan Greenspan said on Sept. 6 that forces behind current market turmoil are “identical” to previous economic upheavals, including the 1987 stock-market crash and the aftermath of the 1998 Russian debt default and collapse of hedge fund Long-Term Capital Management LP.
The central bank cut its benchmark rate three times between September and November 1998. The dollar ended the year 13 percent weaker against the yen, and Treasuries fell for three straight quarters starting in the period ended Dec. 31, 1998.
“We need to keep the 1998 experience as context because a cut in rates will be accompanied by a wave of liquidity that tends to ignite inflation,” said Alexandra Ralph, who helps oversee the equivalent of $2 billion in bonds at Artemis Investment Management in London. “The market is pricing in a considerable amount of interest-rate cuts and quite a lot of flight to quality, so it’s a good time to sell.”
Government and central bank holdings of U.S. government debt at the Fed fell by $46.1 billion from the week ended July 25 to the week ended Sept. 5. They climbed to a record $1.25 trillion in July from $574 billion in June 2001.
Japanese investors, who held $612 billion as of June 30, are on course to cut for a third year, according to the Treasury. China trimmed its U.S. debt by 3.4 percent in the second quarter to $405 billion, the first reduction in three years. Taiwan pared by 10 percent in the past year to $57.5 billion, while South Korea slashed holdings 25 percent this year to $50 billion.
“The only component we can be confident about as nations diversify currency reserves is that Treasuries will be sold,” said Sean Callow, a strategist in Singapore at Sydney-based Westpac Banking Corp., Australia’s fourth-biggest lender.
Mizuho Asset Management Co. expects the dollar will gain as investors seek a haven in U.S. government debt.
“People will withdraw money from riskier markets,” said Akira Takei, who helps oversee the equivalent of $25.9 billion at Mizuho in Tokyo. “The U.S. economy is on the verge of a recession so we should increase U.S. Treasuries.”
Merrill Lynch’s main index of U.S. government securities returned 3.3 percent for July and August. For investors in Japan, the biggest holders outside the U.S., the index lost 3.1 percent after accounting for changes in the currency.
Asian central banks also reduced Treasuries last month in an effort to curb dollar gains against their currencies. Taiwan’s central bank cut its currency reserves by $4.9 billion in August, mostly by selling U.S. bonds, George Chou, a deputy governor of Central Bank of the Republic of China (Taiwan), said in an interview.
Even before the flurry of sales, more nations were starting to shift foreign-exchange reserves away from U.S. government bonds.
Taiwan lawmakers are discussing whether to set up a fund to seek higher returns, Chou said. China is starting a fund to do the same for some of its almost $1.4 trillion in reserves. The fund raised $79 billion selling debt to the central bank last month.
China will likely, and appropriately, “reduce its holdings of dollar assets to get higher returns,” said Ha Jiming, chief economist in Beijing at China International Capital Corp., the nation’s largest securities firm. Ha attends central bank Governor Zhou Xiaochuan’s quarterly meeting with the nation’s lenders.
The $50 billion Qatar Investment Authority said on Sept. 4 it is looking for options in Asia to counter a weak dollar.
Sumitomo Life Insurance Co., Japan’s third-biggest life insurer, and Fukoku Mutual Life Insurance Co., the nation’s eighth-biggest, purchased contracts that profit from a decline in the dollar to hedge their U.S. debt.
It would take a further 5 percent decline in the U.S. currency for Sumitomo Life to buy Treasuries, according to Masayuki Yoshihara, who helps manage the equivalent of $25.9 billion of non-Japanese debt at the firm in Tokyo.
“We’re not so bullish on the dollar,” he said.
The rigorous will recall that by definition, current account deficits have to be funded by a corresponding capital account surplus, meaning that our current account deficit will somehow have to be financed. However, if the dollar tanks, presumably the current account deficit will shrink, and the capital account surplus might be financed less by purchases of liquid financial instruments and more by illiquid investments (real estate, foreign direct investment and other hard asset purchases), which would have the effect of withdrawing foreign capital from the credit markets.