U.S. Leans on Domestic Bond Buyers

By Daniel Kruger, bond market reporter

The U.S. government has been issuing more debt, but it's not getting more foreign buyers in the door.

As a result, U.S. investors have so far financed all of this year’s increase in the federal government’s borrowing.

Foreign holdings of the debt have remained essentially flat, though the government’s borrowing has risen by $500 billion, giving foreign investors the smallest share of U.S. government debt since 2003.

Even as yields on Treasury securities have risen to multi-year highs, foreign demand for debt at government bond auctions has slowed to the weakest level since 2008. Yields rise when bond prices fall.

The drop in demand is happening as Treasury yields approach their highest premiums over German and Japanese debt since the 1980s and as the dollar is in the middle of a rally that caught many investors by surprise. The drop-off in foreign interest also comes as the Federal Reserve is reducing the size of its government bond holdings as part of an effort to restore monetary policy to precrisis norms.

Investors and analysts cite two impediments that are discouraging foreign investment. One is the strength of the dollar has made it more expensive for investors in Japan and Europe to hedge the currency risk of buying Treasurys. The second is a new concern about the sustainability of U.S. borrowing practices at a time when the Trump administration is forecast to run a series of trillion-dollar budget deficits beginning as soon as 2020.

The hedging costs are “so high and so punitive that it’s no longer attractive” to buy Treasurys, said Torsten Slok, chief international economist at Deutsche Bank. The cost is typically close to the premium of short-term U.S. government bill yields over short-term yields overseas. Those rates are compared with short-term government debt yields, which are closely tied to each market’s central bank’s policies. The Federal Reserve is holding its target rate in a range between 1.75% and 2%, while rates for the Bank of Japan and the European Central Bank are negative.

At the same time, some foreign investors are concerned that the $1.5 trillion tax cut passed by Congress in December will over-stimulate the U.S. economy, leading to an acceleration in inflation and potentially higher bond yields and interest rates.

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