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A new story developing in the U.S. Treasury market is that of waning foreign demand.
Since 2013, when the Federal Reserve announced it would be ultimately winding down its bond buying program, monetary policy among the 4 largest developed bond markets has diverged, most notably between the U.S. and both the Euro region and Japan. While the U.S. has been incrementally tightening its monetary policy, the BOJ (Japan), the BOE (UK) and the ECB (Germany) have continued to remain more accommodative – including still negative policy rates for the BOJ and the ECB. With this shift, rates for government debt have also diverged, with U.S. rates offering much higher nominal yields than their developed market counterparts, especially Japan and Germany (the high quality benchmark for European sovereign debt).
As a result there has been quite a bit of demand from foreign investors in those two regions for U.S. debt, which has acted as a support mechanism for U.S. rates. Many of these investors are large risk-averse entities such as pension funds and sovereign wealth funds, who hedge out the currency risk. As demand has increased, so has the cost to hedge Treasury purchases, so despite some of the widest yield divergences in years, if a Treasury purchase is fully hedged for currency risk the yield return is lower for Japanese and European investors due to the increased cost of cross-currency basis swaps. In the last few months we have seen net selling from both regions.
This is the first time since 2012 that net selling has emanated from the Eurozone, and Japan’s 3 month net sales are the largest since April 2014. China is another major holder of U.S. Treasury paper, and as the nation attempts to defend its currency amidst a flight of domestic capital, it too has been selling large amounts of its Treasury holdings, as evidenced by the drop in its foreign exchange reserves.
If the current trend continues, some investors worry there could be upward pressure on U.S. rates. However, there are several reasons to expect only a limited impact on the Treasury market, and on longer-term yields in particular.
First, most foreign holdings are short term in nature (about 75% are less than 10 years to maturity), and therefore selling or lack of buying will only have a marginal impact on longer-term notes. Second, while the current yield differentials are not attractive due to the cost of hedging, if rates were to rise only marginally European investors would once again enjoy a yield pickup for a safe haven asset. Finally, there has been an increase in demand for Treasuries from large domestic buyers who do not have any hedging concerns and see the marginally higher rates as an opportunity.
Ultimately, we believe rates will gravitate toward fundamental value, which is driven by domestic growth and inflation as well as expectations for the future path of the Fed Funds rate (which, in turn, is generally correlated with growth and inflation). In that same vein, while there has been a recent upward trend in inflation as commodity prices, particularly energy, have risen, core inflation rates (excluding food and energy) have lost some steam and GDP growth remains steady but low.
