January 18, 2012 5:43 pm
Central banks curb their appetite for Treasuries
Anxious investors are buying, so is the Federal Reserve. But many of the world’s central banks are doing the opposite – offloading US Treasury bonds, and at a record pace.
A closely watched gauge of foreign appetite for US sovereign debt – the Treasury International Capital or Tic flow report, which includes private and official flows – on Wednesday showed solid demand for Treasuries in November.
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This was hardly a surprise. Demand for US debt has been robust, despite last year’s downgrade of the US triple A credit rating by Standard & Poor’s, largely because of the financial turmoil caused by the eurozone debt crisis. That strong demand has extended into the new year as illustrated by last week’s sale of 10-year notes at a record low yield of 1.90 per cent.
Yields on benchmark Treasury debt in the secondary market have fallen from about 2.4 per cent in October to a low of 1.84 per cent as of Wednesday. Last year was the best for long-dated US debt since 1995.
But the retreat by foreign central banks is a warning that not all players in the bond market are happy with such meagre returns on offer, particularly with annualised core US inflation running at more than 2 per cent.
Of the $10tn in outstanding US Treasuries, foreign holders account for some 48 per cent of the market, with official investors such as central banks a significant presence. Since late August these investors have cut their Treasury holdings by $95bn, with $68bn sold in the past six weeks as the dollar has strengthened and emerging market economies have experienced outflows. A fall in the value of emerging market currencies against the US dollar has reduced the need for their central banks to recycle foreign exchange reserves back into US bonds.
“The decline in custody holdings with the concurrent rise in the dollar suggests the composition of flows into the US may have changed,” says Marc Chandler, head of currency strategy at Brown Brothers Harriman.
The fall in so-called custody holdings was temporarily offset in November by Japan buying $60bn in Treasuries as it recycled dollars acquired in its currency intervention in October, the latest Tic data show. By contrast, China’s Treasury holdings at $1.13tn extended a decline from their peak of $1.17tn in July and are at their lowest since August 2010.
China’s selling is expected to accelerate in the coming months as the country recently reported its first quarterly decline in foreign exchange reserves since 1998 during the last three months of 2011.
But not all of the selling has come from China. Hong Kong and Russia have been reducing their holdings over the past year.
Switzerland, for its part, while up on the year, has been selling Treasuries since September after setting a currency peg versus the euro.
“It would appear that other nations besides China have been reducing their holdings of Treasuries at the Fed,” says Lou Crandall, economist at Wrightson Icap. “Still, the turnaround in the growth rate of China’s currency reserves since the summer helps explain the change in the trajectory of the custody accounts.”
Since August the US dollar has rallied nearly 10 per cent on a trade-weighted basis, while custody holdings of Treasuries have fallen from a peak of $2.76tn to $2.6tn as of last week.
“It is no surprise to see this type of liquidation by official accounts as the dollar is stronger and a sub 2 per cent 10-year doesn’t work the charm,” says William O’Donnell, strategist at RBS Securities.
Sales by foreign central banks, though, have been overshadowed by the Fed’s buying under its “quantitative easing” programme, the eurozone crisis propelling investors to the relative safety of US sovereign debt and proposed capital rules pushing US banks to own more government bonds.
“There is little doubt that the Fed’s ‘Operation Twist’ is keeping yields down,” says Gerald Lucas, senior investment adviser at Deutsche Bank. “When the Fed is buying, you don’t fight them.”
High-profile investors such as Bill Gross at Pimco also advocate owning Treasuries. His bond fund increased the proportion allocated to Treasuries to 30 per cent in December, the most in more than a year. There is a strong chance that, even when the Twist ends in June, the Fed will continue to support US government bond prices via another round of quantitative easing.
Keeping yields low remains a priority for policymakers as long as the US economic recovery is lacklustre. As a result, many in the bond market expect a third round of quantitative easing, or QE, in the spring or early summer. A new round of QE that replaces the Twist could in turn stoke a “risk-on rally” that boosts emerging markets and results in renewed accumulation of dollar reserves by their central banks, and more purchases of Treasuries.
“QE 3 will happen, you are going to see growth roll over from 3 per cent to averaging under 2 per cent for the first half of 2011,“ says Eric Green, economist at TD Securities. “The Fed has a high tolerance for inflation but not for sub-par growth and QE is likely by April.“
Daniel Katzive, foreign exchange strategist at Credit Suisse, says: “QE has generally been negative for the dollar and a boost for risk appetite, which is a good recipe for emerging market outperformance. More flows into EM will mean more reserve accumulation and buying of Treasuries.”
Copyright The Financial Times Limited 2012.
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