“There can be no time, no state of things, in which Credit is not essential to a Nation.” —Alexander Hamilton, Report on a Plan for the Further Support of Public Credit, 1795. (Photo by steinphoto/iStock.)
From Brexit to Trump, 2016 was a year of change—and another big one recently came to light, when the US Treasury’s latest data showed foreign investors were net sellers of Treasury bonds for the first time in over a decade. Not only did China sell off a boodle in an effort to prop up the yuan, the UK, Japan and others reduced their holdings as well. We’re inclined to call this an “interesting observation” and move on, as US investors’ abundant delight to pick up the slack kept yields in check, proving once again that demand is multifaceted and for every seller, there is a buyer. Yet some worry this is only temporary and further reductions in foreign holdings—not just Chinese—will cause yields to spike. However, recent history has repeatedly argued otherwise. Regardless of the source, overall demand for Treasurys remains robust.
Yields Benign While Foreigners Sell
It is true that over the decade-plus when foreign entities were net buyers, Treasury yields fell. But tying this solely to foreign demand is an error. It ignores the myriad other factors driving long-term rates, not least of all inflation expectations (benign) and Fed policy (buying long-term bonds as part of quantitative easing).
Bond markets move on supply and demand. Although Chinese and other official sector foreign demand has waned, total demand isn’t hurting. US pension funds, insurers, banks, money market funds and mutual funds have stepped up their purchases. Foreign sellers have found more than enough buyers willing to pay a premium, which is how 10-year Treasury yields finished 2016 mostly flattish, rising just 18 basis points. That speaks volumes about the US’s creditworthiness.
Markets’ ability to adapt is well documented. For years, skeptics warned America is in hock to foreign creditors, dependent on them alone for cheap financing. Yet the data disagree. Consider China (Exhibit 1). According to official data (blue line), China’s US Treasury holdings peaked at $1.3 trillion in 2011, wobbled around there for a while, started slipping in 2014 and tumbled last year. Many believe China holds additional Treasurys through proxies in Belgium and the UK, and if you add them all together (which is too blunt, but this is for illustrative purposes), there is a $421 billion drop since 2014.
Exhibit 1: Yields Low No Matter Where China’s US Treasurys Are Custodied
Source: St. Louis Federal Reserve and U.S. Department of the Treasury, as of 2/10/2017. 10-Year Treasury Constant Maturity Rate, 3/31/2000 – 1/31/2017. Treasury International Capital (TIC) System Major Foreign Holders of U.S. Treasury Securities, 3/31/2000 – 12/31/2016.
Regardless of how you measure China’s holdings, the selloff didn’t coincide with massively higher US Treasury yields, which are down since it began in 2011. It’s fair to point out yields did tick up as China sold Treasurys in last year’s second half, but even so, they remained below levels seen for most of 2013 and 2014. Moreover, the latest December Treasury report shows China was a net buyer in December, even as yields rose. And the uptick lasted all of a month and a half. 10-year yields are down nearly 20 basis points since mid-December.
Why Demand Is High
As for what’s next, it’s entirely possible last year was a blip and foreign investors resume buying apace. With most European and Japanese debt yielding far less than Treasurys, investors globally have every reason to buy America’s higher-yielding IOUs. Either way, however, demand—whether foreign or domestic, institutional or retail—is demand. Where it comes from doesn’t fundamentally matter.
Investor appetite for US Treasurys should remain strong, regardless of geography. Consider the essential role they play in the world’s financial system. Have Treasurys stopped being vital to global financial market functioning for trade, collateral and capital? Are they no longer playing their critical role as a benchmark reference rate for all other debt? Absent the affirmative, there is no real reason for the world to shun Uncle Sam.
First, there is no substitute. When it comes to the depth and breadth of the Treasury market, they’re the world’s “safe asset” par excellence—the bedrock security upon which the world’s financial architecture is built. Treasurys are always and everywhere “money good.” When credit ratings agencies downgraded Treasurys, they rallied. In a US-centered global financial crisis, they rallied. When Congress played chicken with the debt ceiling in 2011, they rallied. There is some chatter about President Trump’s proposed fiscal stimulus and feared inflation driving investors away, but to the extent it’s true, it falls under normal short-term volatility that accompanies heightened uncertainty. As uncertainty falls, wobbles tend to even out.
Second, they also currently have a higher yield across maturities than any comparable contenders. All else equal, money flows to the higher-yielding asset. There is around $9 trillion in negative yielding debt globally and trillions more well below comparable-maturity Treasury yields. This built-in demand keeps US rates anchored. Bid-to-cover spreads show Treasury auctions consistently more than two times oversubscribed—demand is over twice the amount supplied.
Third, inflation risk is benign, which is another fundamental reason why demand is high. Private investors care less about where demand is coming from than whether inflation might erode real returns (and demand higher rates to compensate). There are various ways to measure inflation expectations—surveys, implied by inflation-indexed bond “break evens,” futures markets. They aren’t predictive and only reflect conventional wisdom, but as sentiment gauges, they suggest markets are far from worrying about runaway inflation.
With US rates relatively attractive globally and inflation quiescent, we don’t expect sharp moves higher and we think they probably finish the year below where they started, consistent with solid demand fundamentals, both foreign and domestic. The myth of demand resting on one swath of buyers isn’t unique to Treasurys—we’ve seen it throughout the equity market, too. At various times the stock market’s fate has been pegged to retail investors, “money on the sidelines,” stock buybacks and, going back full cycle, foreign demand—think (ruthless) Japan, Inc. from yesteryear. As the world turns, so does the one thing holding it up apparently, or so the media attests. But in broad markets like stocks and US Treasurys, it’s wrong. These are auction marketplaces, with many participants. The totality of buyers, and their willingness to pay higher prices (or not) are what ultimately determine pricing.