"It's Gone" -
Why Foreign Demand for US Treasuries Has Disappeared by
Tyler Durden
8/23/16
Last week's TIC data
confirmed something the Fed's Treasury custody account has
indicated for the past several months: foreign demand for US government bonds
has not only tumbled, but there has been aggressive selling.
So much so, in fact, that in the past
12 months foreign central banks have sold a gargantuan $335 billion in US
Treasuries (and $242 billion when looking at all foreign
transactions including private).
But how is this possible: after all
the yield differential between US government bonds and the rest of the DM
complex is approaching record wides.
It turns out that the answer lies in
the ongoing blow out of the cross-currency basis, i.e., the implicit global
dollar shortage, something we highlighted
several months ago, and which has only gotten worse in the months since,
following the spike in dollar hedging costs and short-term funding costs (see
Libor).
The collapse in demand for US paper as
a result of the blow out in swap spreads is the topic of this morning's FX
Daily by Deutsche Bank's George Saravelos who notes in a note titled "It's
Gone" that "a remarkable hunt for yield has taken place over the last
few years. Foreigners have fled negative rates and flocked to US fixed income
to take advantage of positive rates. Currency hedging these purchases has been
a popular strategy: investors buy long-end bonds and use short-dated forwards
to eliminate the FX risk."
However, apropos to the current basis
spread environment, something significant has happened in recent months: buying 10-yr US treasuries is no longer
profitable. It is not only Europeans or Japanese, there now
isn’t any global fixed income investor that can make decent money by buying
hedged USTs.
Even more remarkably, the reason
behind this lack of return isn’t that long-end yields have compressed: the rate
differential between the US and the rest of the world has stayed quite stable. Instead, it is diverging central bank
policy (Fed hike vs cuts elsewhere) and the widening in cross-currency basis (which
is the cost of hedging using a forward over and above that implied by covered
interest rate parity; the drivers are regulatory tightening, differing investor
liquidity and hedging preferences, as well as bank credit risk) that now makes it very costly for
investors to hedge.
Deutsche Bank draws three conclusions
from these simple observations.
First, it is hard to see
the relentless foreign buying of hedged US fixed income continuing at the same
pace. Unless other bond yields decline deep into negative territory (they are
already zero), there may be limits to how much more UST yields can compress.
Second, the rise in forward
costs is bullish USD. If
investors want to pick up AAA yield, they will have to do so unhedged, which
will generate demand for dollars. If they don’t want FX risk,
investors will have to buy higher-yielding corporate bonds or other riskier US
assets.
Finally, cross-currency
basis and the US short-end may prove material drivers of global capital flows
going forward. On the one hand, the widening in cross-currency basis is
essentially a “tax” on hedging costs distorting global capital flows. On the
other hand, a Fed
tightening will make FX hedging even more expensive, counter-intuitively
forcing investors to increase, rather than reduce, FX, credit or duration risk.
Keep an eye on the Fed's weekly
custody holdings of Treasuries for the most current data if basis hedging is
pushing even more foreigners out of the world's most liquid fixed income
security.
Comments
US
government spending cuts are long overdue. We sell Treasuries to fund our
federal government debt and nobody wants them.
So, if we can’t get anybody to fund our debt, we need to reduce our
debt. We need to replace our entire
federal government with people who are a lot smarter and less corrupt than the
current crop. We are currently careening
off the fiscal cliff.
Norb
Leahy, Dunwoody GA Tea Party Leader
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