Foreign demand for US Treasuries has been in decline just as issuance is on the rise due to an expansionary fiscal policy. With the Fed normalising its balance sheet, one of the primary sources of demand for US government paper is disappearing, adding to the net supply of securities. In addition, ECB QE, which has been critical in suppressing global term premia by driving huge capital outflows from the euro area, will cease at the end of December. While the central bank will keep reinvesting the proceeds from maturing assets in its portfolio, its role as a primary provider of global central bank liquidity is waning rapidly. It is not surprising, then, that higher yields remain one of the biggest worries for investors. In this note, we focus on the demand for US Treasuries from foreigners, which will likely remain on a downward path.
The share of foreigners’ holdings of US Treasuries has fallen to 41%, a 15-year low, from 45% just a year ago. The proportion was as high as 55% during the global financial crisis. A crucial reason for the decline is the quickening rate of issuance. But another is waning non-US demand. As the chart shows, foreigners swung from being net buyers of $793bn of Treasuries (12-month sum) in September 2010 to net sellers to the tune of $339bn in November 2016. While overseas interest in US government debt has recovered since then, it is still relatively modest.
EM Asia (China in particular) has been the chief buyer of US Treasuries. But things changed in 2015. The sharp yuan revaluation exerted huge depreciation pressure on emerging market currencies, especially Asian EMs. As Asian central banks rapidly depleted their FX reserves, their net buying of US Treasuries dwindled. Even before 2015, fears of a withdrawal of policy support by the Fed, stoked by the ‘taper tantrum’ episode of mid-2013, led EMs to run down their FX reserves and buy fewer US government securities. Similar concerns have emerged more recently with an escalating trade war and the tightening of Fed policy. RMB/USD has lost 10% since April and we expect the currency to shed another 10-15% mid-2019. FX reserves in Asia have fallen by $82bn since April, coinciding with the region’s drooping demand for US Treasuries. The pressure on other EMs is likely to get worse.
The euro area has also been an important source of demand for US government debt, especially since the ECB signalled QE. But the hedged 10y US yield pick-up for an EA resident turned negative at the end of 2017. It has also disappeared for other DM investors, including those in Japan. With the Fed tightening policy further and the front end of the yield curve likely to remain anchored close to zero in the EA and Japan, US Treasuries may not be an attractive investment for some time for EA and Japanese investors that choose to hedge their FX risk.
What could change this? The most direct resolution would be higher US yields. This would strengthen the dollar further, exacerbating the negative feedback loop with EM reserve managers. Elsewhere trade war fears could fade and reignite interest in US government debt. Or a steeper US yield curve could make treasuries attractive again for foreign investors. Or DM foreigners’ investment behaviour changes and they choose to make un-hedged investments in USTs – but again this new USD demand exacerbates the EM reserve managers’ problem. We therefore struggle to see a big revival in interest on the part of non-US residents. Funding the expanding US fiscal deficit will be no walk in the park. We will explore some of these themes in more detail in our next Global Financial Trends.
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