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Why China Liquidations May Not Spike US Treasury Yields
Via Scotiabank's Guy Haselmann
There has been quite a bit of market chatter this week about how central bank selling of foreign exchange (FX) reserves could cause Treasury yields to soar. The market has branded this action ‘Quantitative Tightening’; borrowing the term from a note written by a London-based markets strategist. Investors seem quick to conclude that it will result in higher yields on Treasury securities. I disagree with this simplified assumption and will use this note to explain why.
Yes, I remain bullish on long-dated Treasuries securities.
First some facts. No one disputes that central banks have been selling reserves. Aggregate global foreign exchange reserves fell to $11.43 trillion in Q1 from $11.98 trillion last summer. The aggregate amount most likely fell even further in Q2 and Q3 as Chinese economic growth concerns impacted global markets. These reserves are mostly held in G7 currencies, 64% percent of which are held in US dollars. Since the aggregate amount is measured and reported in US dollars, it should be noted that part of the decline is due to the fall in dollar terms of the reserves held in euros and yen.
To understand its impact on Treasuries - or German, UK, or Japanese bonds for that matter - it is important to understand why central banks have been selling. The decline (selling) is driven by a combination of factors, such as: a Chinese economic slowdown; the preparation of a looming Fed interest rate hike; the Renminbi devaluation; a depreciating domestic currency; capital outflows; and lower revenues from collapsed commodity prices.
How do these factors lead to the selling of FX reserves? Put simply, some countries are selling reserves in an attempt to either support falling local currencies or to offset capital flight. If an investor, for example, sells a Renminbi asset for dollars, China can sell some Treasuries to buy the Renminbi and support its currency and currency peg. If the investor chooses to invest the USD into Treasuries, then there is no net effect.
More importantly, a probable driving force behind this transaction could be that the outlook for economic growth and inflation has fallen. In addition, there may simply be a flight to the safety of Treasuries in a world of growing central bank and political uncertainty (and one of greater imbalances and instability). Furthermore, as global capital markets have entered a new higher volatility regime, portfolios are forced to decrease risk accordingly. Any central bank selling will be worse for equities than Treasuries.
Admittedly, de-risking is not a one-way bullish bet on bonds since leveraged carry trades and ‘risk-parity’ portfolios will need to do some selling. This is difficult to quantify. In addition, a slower growth world has depressed the price of oil leading to fewer petrol dollars being recycled back into Treasuries.
However, I believe demand for Treasuries will more than offset central bank selling. Treasury selling by central banks is temporary, while the economic factors causing the action will be longer lasting. Weaker foreign currencies will mean cheaper goods being sent to the US. This will keep downward pressure on US consumer prices, and the proceeds of which will be recycled into US Treasuries.
There is no doubt that the Chinese economy is in a material economic slowdown. Policy officials’ aggressive actions and scare tactics against equity short sellers could continue to cause capital flight. However, this does not mean that China is going to sell large quantities of Treasuries. There is too much co-dependency between the US consumer and Chinese exporter.
Destabilizing the US Treasury market with large sales would be tantamount to shooting themselves in the foot. Therefore, if capital flows became too large China would rather impose a penalty on outflows, than sell too many Treasury securities. Last week, Beijing imposed a 20% penalty in Renminbi forwards - that bet against currency depreciation.
There was huge liquidation of FX reverses during the 1997 South East Asian currency crisis. The 10-year Treasury bounced around in a volatile range for many months, only making slow progress to lower yields over time despite scary market conditions. Ironically, it was only after the IMF granted loans, and the selling dissipated as the crisis eased, that Treasury yields fell markedly.
In addition, demand from private pensions should increase. Penalties for underfunding will rise again on January 1st, so the incentives to expand LDI will increase. There is a shortage of high quality duration.
Lastly, the Fed may choose a reinvestment schedule for maturing Treasury securities in 2016 that keeps the weighted-average-maturity of its balance sheet stable. If this happens, duration will be extracted from the secondary market to fix the duration of its balance sheet.
Foreign Demand for Dollars
Due to low rates (zero lower bound), the amount of US dollar issuance by foreign corporations has risen from around $2 trillion in 2007 to around $8 trillion today (a 4X increase). I will guess that the average weighted maturity of this new issuance is 6 years. That would mean that any debt issued in 2009 is coming due this year.
If the money stayed in US dollars, repayment would be less difficult. However, much of the proceeds were repatriated into domestic currencies. Since many foreign currencies have depreciated by 20%-60%, these liabilities have increased significantly in local currency terms. Many companies are scrambling to get dollars or hedge their currency exposures as they prepare to meet their obligations.
Central banks may have to find clever ways to offset or smooth these flows. Relative to the size of their economies, $8 trillion in outstanding liabilities is an enormous amount. This is likely one of several forces giving a relentless bid to the USD against certain currencies.
September FOMC
A sporting event is most enjoyable when the game is fair and competitive and when referees are rarely noticed. Central Banks should be viewed in the same light. To their dismay, they would admit that they are too visible and the source of daily news. Part of the problem is that central banks have entered a dangerous cycle of investors expecting more stimuli for each and every economic wobble. (Hope-ium is highly addictive.)
The markets began today in ‘risk-on’ mode due to ECB quasi-promises of doing whatever it takes.
The first hike in nine years has been lingering above markets for well over a year. Rightly or wrongly, there have been reasons and excuses to delay it. Further delay will be damaging to markets and destructive for confidence. The time for a hike has arrived. The best way to arrest these unhealthy conditions is to ‘rip the band aid off’ by hiking in two weeks and then sitting back and watching.
Elevated market volatility or international fragility should not deter the Fed from hiking. A pause would actually cause more uncertainty and keep a hike looming over the market for longer.
One reason, the US Treasury curve has been steepening is the belief that the Fed will delay hiking rates until 2016. Some investors believe the Fed prefers a steeper curve; thus supporting their expectations for delay. I disagree with that prediction and rationale.
I agree that a hike would almost assuredly flatten the curve. This would occur because investors would either think that the Fed made a mistake, or because they would decrease expectations for growth and inflation given the fragility of the international economies.
However, I believe the Fed would not be bothered by a drop in long yields, because it would help support the housing market. Moreover, banks (who benefit from a steeper curve) already receive a subsidy (arbitrage) from interest on their excess reserves, and do not receive much margin in loans anyway.
The bottom line is that I remain a bond bull and advise investors not to give into the hype of Chinese selling. (Moreover, the employment report tomorrow at this point does not matter.) I expect long-dated yields to fall materially despite an interest rate hike by the FOMC at the September or October meeting. The next 50 basis point move in 10’s and 30’s is to lower yields and likely to happen before the end of the year.
“Over investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money.” –Irving Fisher
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"There is too much co-dependency between the US consumer and Chinese exporter.
Destabilizing the US Treasury market with large sales would be tantamount to shooting themselves in the foot."
If it comes to it, China will take a hit on the collapse of the UST market, but would more than make up for it on the re-valuation of gold... If the US keeps pressing China on all fronts, I expect this exact scenario to play out...
I love all the bullshit.
1. China sells UST
2. US Fed member Banksters buy UST
3. Banksters launder to "Caribbean Banking Centers" so the purchases do not show up on their books
4. USTs later sold to Pension Funds as equities crater
5. "Caribbean Banking Centers" repay parent Banksters plus 1%
6. Banksters falsify profits on bond trading as Equities take a shit
7. Losses charged to taxpayers, profits paid to overseas investors and the Fed
8. Wash, Rinse, Repeat
Exactly, John. That's why they call them "efficient markets". The market knows exactly how to most effiently front-run any policy change and sweep the dead bodies under a REALLY FUCKING BIG carpet.
The gold re-evalutation will not occur until the dollar at first strengthens (relative to other currencies). The fed is hiking rates so that (usd up) will happen, in order that they(tbtf usbanks) can get all of the fed gold they just sold (at suppressed price) back at a lower price (further supressed price), by pressuring gold holders to sell to remain solvent. I guess the real question is how long or how much of the gold "material" the black players will have to give back to catch up with the lead in "development" of the white player to avoid checkmate. If its not alot, black players will win, if its most of it, black player loses anyway. Either way expect all the pawns to leave the chessboard (thats us).
Then the gold re-evaluation will occur. The entire thing is a ginormous headfake. Everyone else's assets devalue relative to held USD, who will buy up assets and hold, dumping any losses on USTaxpayer in the great reset.
Tl;dr?
usd up (QE in yuan,yen,EU)
stocks down
gold down
brics double screwed
EU severly devalued
until
usd crash
stocks up?
gold UP
xfer of reserve currency to the "pheonix/sdr/wtfbbqcatchallterm"
China never worries about shooting themselves in the foot. Only focus is shooting their enemies in the head.
And if their foot is on their rival's head they won't hesitate to shoot themselves in the foot.
What a moron! The problem is NOT the "long term" treasuries! It is the 2ys and 5ys. THOSE are the problem and the ones that they are liquidating.
An apples and oranges comparison, but a squid type.
Circular logic. Lots of bad assumptions. Very poor analysis and mostly wishful thinking. Mostly.
So the jobs report will be bad, and it will matter. Thanks for the hot tip. VIX to the moon! (until about 3:40)
Listen up and listen good, Pilgrims
There are 2 ways the Chinese can sell Treasuries.
First, if they're held as regular marketable securities and transacted vis the open market, custodied somewhere like any other funds (think Cedel/Euroclear or alternative in Belgium, etc.) then they're usually sold into the open market. The FED can offset the sales via direct purchases, a la QE efforts which will in all likelihood, be necessary even without Chinese sales, simply because the global economy is going pear shaped.
The second main way is most CB's hold large Treasury postions directly at the FED, in like a custody account there. If they sell in that case, the FED simply buys them "direct". In which case, the sale is never even seen let alone felt by the open market.
Then .... the big question is what is done with the proceeds? Are they applied to 4X, PMs, other debt obligations or equities, etc? Are they re-loaned to somewhere like Venezuela in exchange for dibs on oil or other resources, basing rights, etc? That's where and when the poop meets the fan, let alone any collateral calls, etc., keyed by the secondary transactions.
Overall, the longer term trend in Long Term yields will and always has, followed the longer term trend in inflaiton as measured by commodity prices. Go figure.
Getchur income now while it's still a positive number.
Chinese dumping of Treasuries is a long term bugaboo of the political right wing, part of their closet of anxieties, along with black people and brown people and taxes on rich people.
Before the Chinese got richer, they worried about Japanese dumping Treasuries. The Japanese are our biggest creditor now, but they don't seem Yellow Peril enough anymore, so the wingers concentrate on the Chinese.
It ain't gonna matter. They could liquidate all their holdings and there might be a temporary blip-up in interest rates.
What if the Fed was really did need to be the buyer of last resort? So their 3 trillion dollar balance sheet becomes a 4 trillion dollar balance sheet. If 3 trillion made no difference to the world economy, what will another trillion do?
Stick to the "hippy" business; it's less complicated for you.
One of the most misunderstood topics is China's US$-denominated reserves. They were accumulated over 20-25 years as a result of having a non-covertible currency that required the PBoC to buy US Treasuries to hold as reserves against the growth of US and Japanese supranational firms' FDI investments and associated Chinese banks' loans/deposits.
US and Japanese FDI peaked in 2012-13 and have now begun to contract, requiring the PBoC to sell Treasuries to facilitate the repatriation of funds from China via Fed and other central banks' custodial accounts.
Like so many other epochal events, one day this might be understood, but don't hold your breath, as the Power Elite and banksters don't want you to know, thank you very much. Stay dumb a little longer while the banksters get positioned to pull the plug on the bubble machine yet again.
MOAR QE (but not quite yet)!!!
One of the most misunderstood topics is China's US$-denominated reserves. They were accumulated over 20-25 years as a result of having a non-covertible currency that required the PBoC to buy US Treasuries to hold as reserves against the growth of US and Japanese supranational firms' FDI investments and associated Chinese banks' loans/deposits.
US and Japanese FDI peaked in 2012-13 and have now begun to contract, requiring the PBoC to sell Treasuries to facilitate the repatriation of funds from China via Fed and other central banks' custodial accounts.
Like so many other epochal events, one day this might be understood, but don't hold your breath, as the Power Elite and banksters don't want you to know, thank you very much. Stay dumb a little longer while the banksters get positioned to pull the plug on the bubble machine yet again.
MOAR QE (but not quite yet)!!!
Investors seem quick to conclude that it will result in higher yields on Treasury securities. I disagree with this simplified assumption and will use this note to explain why. Yes, I remain bullish on long-dated Treasuries securities...
I agree that a hike would almost assuredly flatten the curve...
This is the very first author who I feel even has the slightest clue as to how shit really works. Every dumbass and his brother who authors a piece or comments on here about treasurys all stupidly assume that a ffr hike would cause long term rates to rise. BULLSHIT! Nice work Guy.
I was going to post up my own along similar lines, but I'm just going to up-vote you instead. EXACTLY what I was thinking.
My line of reasoning comes from the following: QE didn't drive rates lower (they were already as low or lower than they are now). So why should QT instantly drive them higher?
That's only one of many ways you can arrive at a similar understanding.
Yep. A tightening now, against this economic (global) backdrop would cause a Bull Flattener.
Cure flattens as long rates rally.
And it Could Be Big Time Charley.
The decision to hike moves the yield curve closer to inversion (never mind the possible noble cause of flattening), if the 10-year yield does indeed 'behave'. Within the context of a budding/deepening global depression, why would the US want a flattening curve and a supported US dollar? All else being equal, it would mean that the US would take a larger brunt of the downturn. There goes one more reason for the two largest importers of oil ( US and China) to slow their imports of crude, which may create a negative feedback loop within a lovely petrodollar system that's facilitated the primary support of the dollar for more than 40 years. The missing part here is: create havoc in the Middle East to support higher oil prices. Or, Saudi Arabia caves in and cuts production. King Salman is in Washington, today, you know. And if anyone noticed, the author flew by the point about the petrodollar---though he does admit it is difficult to quantify. How about a trillion dollars of crude traded each day? Fractionally less demand adds up to much more loss to the petrodollar than the peanuts the author suggests will make up for Chinese selling. And what makes the author think that China will be the only sovereign selling Treasuries? That, too, is, "admittedly" difficult to quantify. And we go back to square one. Don't we?
Admittedly, de-risking is not a one-way bullish bet on bonds since leveraged carry trades and ‘risk-parity’ portfolios will need to do some selling. This is difficult to quantify. In addition, a slower growth world has depressed the price of oil leading to fewer petrol dollars being recycled back into Treasuries.
And this is not a direct response to your comment, Knucks. I just wanted a higher place withon the thread that started this discussion. Sleazy. I know.
well you are completely out to fucking lunch.
It was China that was the biggest external holder of MBS paper and look what its selling did there in 2008 ?
The problem? No counter party for MBS. There will "always" be a counter party for USTs. As long as there is a FED.
The headline says that China liquidation may not spike US treasury yields. There's a stone certainty in that healine. Impossible to argue against it. Of course, it is equally impossible to argue against the obverse headline China liquidation may indeed spike US treasury yields. Therefore, we can say with certainty that the China liquidation may or may not spike US treasury yields.
It's good to have a little certainty in this ever uncertain world.
Thanks for sharing that with us.
My thoughts exactly.
It WILL spike. IT WILL. ZIRP for... how long? Come on... is this guy serious?
"Blah...blah, buh-blah..." I agree completely.
There's a lot of excitement at the craps table.
What biased garbage. What else would you expect from Scotiabank.
My biased view is this:
If stocks tank, the Fed will make all short rates negative and bring the 30 year to zero to force everyone out of the money market and into stocks.
I think Jim Willie is saying they are going to crash the stock market to chase everyone into treasuries. Kind of a treasuries stick save in the making.
Stocks are toast, they can't control this anymore. Watch PMs physical give the spot price a nasty back hand. This whole thing is going to blow and the world is asking: what took you goddamn Americans so long to rise up. Fuckin' cowards, all full of macho kickin' in third world front doors, but when it comes to sorting out the crap in your own nest you're gutless!
And if your going to dump a pile of treasuries make damn sure you devalue your currency the day before to capture the extra 5% skim Who's searchin for yield now bitchez. Golf clap- well played Xi, well played. textbook fuckin and shove your curve. lol
The Fed is sitting on trillions and trillions of $$ worth of Treasuries it has been purchasing (since no one else wants them these days)
Raising rates would destroy their books . . . they can't and won't raise rates
they will just keep buying while they create endless electronic dollars . . .
What books? Are they ever audited? Those books are what the FED says they are and destroying something that no one else can ever see is somewhat meaningless.
K.I.S.S. Sometimes a cigar is just a cigar. When the biggest owners sell, you should sell, too.
China's payment is in dollars. If they tire of the dollars into treasuries cycle they may decide the time is right for a new monetary system. I agree this would be a major shift but it does appear to be the general direction since the GFC. Being rich in treasuries has palyed a role but the benefit to China may have ended and they may be preparing for the end of the dollar system.
What truly annoys me is the stunning belief that the US petrodollar hegemony will NEVER end ! There are so many people I know that have. made patriotism into a religion & I am serious ! Instead of a religious chorus like t" The Old Rugged Cross" it's the " National Amthem" instead of " The Lord's Ptayer" We have " The Pledge of Allegiance " . Yesterday I had a man & woman scream at me " That it does not matter if China & or Russia sell ALL of their US treasury bonds or of California runs out of fresh water . Because this IS America , This is the United States & the problem is weak , sinful people like me that don't appreciate living in God's land !
" God bless America ,"
I was literally at a loss for words to this religious insanity that it does NOT matter what the USA does or what happens because God will save us & the world will bless fully carry onward .
I am sure this is how many Roman felt in the last days of their empire & yet look how it turned out for them & how far the human race fell as a result !
"What truly annoys me is the stunning belief that the US petrodollar hegemony will NEVER end!"
No, I think most of the belief is that it is highly unlikely for the dollar's hegemony to end any time soon and that is based upon the prevalence of the dollar vs other currencies in world trade (and DEBT) and the lack of any credible currencies to replace it based upon current trade imbalances (the owner of the reserve currency must be a huge IMPORTER) and the likely fall to less relevance of the Euro after the next big worldwide crash, the only real potential competitor. China is in the process of an EPIC crash, plus they are a huge net EXPORTER.
All empires eventually fall. However, I don't see the US empire ending any time soon. There are "sky is falling" types who WANT that to be true for some reason. My belief isn't based upon WANTING any particular thing to be true.
American consumer is dead, ergo the
Chinese manufacturer.
Bunch of morons!
China helped Argentina and Venezuela.
There are other ways to get rid of US treasury bills ...
hehe.
Listen to ScotiaBank like you listen to Goldman... if you need to lose a large amount of your cash in a hurry.
The FFR doesn't matter. That's the real dirty secret.
Only the IOER rate does. Everything else is for show.
What a Spin ? China is selling its reserves because this cost the least damage to its priority in stabilizing its domestic market in order to gain the flexibility to set domestic interests to augment a soft landing. China knows that it cannot control the secondary effects that take place out in the global markets through its action. Neither does it cares and the feelings are mutual. Capital flight to safety in the US$ is different from yield chases. This is exacerbated by the deformed markets with CBs holding money pumps and are market players (the biggest kids on the blocks). It is nostalgia to embrace the notion that Try Prices rise with Yield declines undergirded by demand/supply or vice versa. You don't know when the music changes to another dance. If you want to be in the game, then at least be sure that any pains thru wrong bets are calculated risk taking and not through inhaling Smokes from Charlatans.
If you think that the dollar value will collapse at some moment you better sell your treasuries when they're still worth something and buy gold with it while it is still low in dollar terms or i.a.w. now.
The FED will have to print money to scoop up the massive amount of treasuries sold by the world if they want to keep the Yields down. But of course this all is still theory now.
But you better have a plan when you get punched in the face.
People like me agree with you that you must have a plan.
Right now, the world is at war:
Flooding Europe with refugees to de-stabilize the Euro Zone.
Somebody blowing up big complexes near data processing centers in China.
China putting its ships in Obama's face in Alaska. Ditto for Russia in Syria.
Oil price war being fought by proxy SA against Russia with collateral fallout in the US and Canadian oil patches.
Unknown machinations to destabilize the derivatives markets.
FX manipulation. The full court press to maintain US Dollar supremacy.
Price suppression of gold and silver.
Open threats (unworkable now) to remove cash from the money system).
If you have anything of value, then to keep it, you have to work through the contingencies.
If you have little or nothing of value, does any of this really matter. Yes, after the Draft is re-instituted.
you zh fucktards still don't understand how the game of money and paper works.
china OWNS IOUS THAT PAY A MODICUM OF INTERST AND one you convert to non-interest bearing IOUs' (aka DOLLARS-CASH) FOR THE purpose of EXCHANGING THOSE DOLALRS FOR ASSETS OF EITHER PHYSICAL OR OTHER DENOMINATIONAL VALUE ( BUYING OTHER FOREX OR COMMODITIES ETC...) THAN YOU ARE JUST trading the interest value of the cash for the PURCHASING VALUE OF THE CASH.
well guess fucking what, THEY ARE SELLING THE INTEREST TO BUY THEIR OWN CRAPPY FUCKSHIT DEBT BUBBLE THAT IS IMPLODING IN THEIR OWN YUAN DENOMINATED STOCK MARKET WHICH IS A FARCE.
you think that makes the dollar weak!?!?!?!!!? HEY FUCKTARDS, THE CHINESE ARE LIQUIDATING GOOD DEBT ( AMERICAN DOLLAR IOU INTEREST PAID ON TREASURIES) TO BUY ONE OF THE BIGGEST INFLATED PIECE OF FUCKPIE DEBT PILES CURRENTLY IN THE WORLD , also known as teh chinese financial system.
now, ---i'm a big fan like many of china in the long run. but chanos and many others have it right. china is a total utter basket case WELL BEYOND THE PALE OF WHAT YOU SEE IN THE WESTERN FINANCIAL SYSTEMS.
when you take a billion people and run a new financial emerging market explosive growth 30 year bubble on them, you can bet there will be 'growing pains' beyond the pain of bubbledom you laready see in the west.
so no---interest rates aren't going up becasue the fed and everyone else in the world is just going to SOAK UP THAT INTEREST BUY BUYING THE GOOD DEBT OFF THE CHINESE WITH THEIR DOLLARS SO THE CHINESE GOVVIE CAN SPEND THOSE DOLLARS BUYING chinese stocks!!!
so you have dollar velocity in chinese debt even as the debt is falling in value and defaulting at higher rates. so that velocity just skyrockets and those dollars one way or another circulate in the chinese economy or come back out of china to bid on commodities even as those commodities are falling in value.
ITS FUCKING BEAUTIFUL PEOPLE!.
Didnt expect to find an article written from such an establishment viewpoint here.
"There is too much co-dependency between the US consumer and Chinese exporter.
Destabilizing the US Treasury market with large sales would be tantamount to shooting themselves in the foot."
That shrinking co-dependency is no longer a significant weight in Chinese decision making. You are correct, the Chinese are not trying to destabilize the US Treasury market, they are merely trying to exit and cash in as much as they can while there are still buyers to sell to. US Treasury debt is no longer ´´Good debt´´ in the eyes of Chinese and Russians , its a pyramid ponzi scheme which will crash sooner rather than later. Give me an RMB account and Chinese stocks anyday over $ or US Treasury bills - at least Chinese RMB + stocks are actually backed by Gold + real assets (even if a tad overvalued if still priced above their price one year ago before the bubble began.)
The trouble with your analysis is this: The Chinese and Russians are running BIGGER Ponzis than the US. Much bigger. Thus the flight to "safety".
who in their right mind would hold long term US debt?? it's much the same as Greek Debt, Jap debt, or Pre-1917 Russian Debt. I had some old 1917 dated Russian bonds... guess what, they are worth nothing.
If I had US debt I would sell it too. Would you lend money to a bum?
All this talk that US market is biggest in the world... US can print more...the FED can soak up bonds that no one wants..... blah blah blah...what horseshit. it could all end in a second... As the Soviet experience ended one day, so shall the current US money system.
As the Soviet experience ended one day, so shall the current US money system.
Could you tell me the day? Or at least the week? How about which month. Heck. Just tell me the year.
Let me sum up the article...the world needs our debt. There is not enough excess productivity in the world to fund these out-of-control gov'ts. No one shoots themselves in the foot...unless the alternative is their head. China has to convert a lot of their paper to something of real value.
The concept of a selloff having no effect because nany FED will counteract with buying is silly, not that they will not buy, but that it will have an offsetting impact.
For every sale there has been a buyer, but this doesn't counter the selloff. No mastermind can undo this, but this can undo us.
http://www.reuters.com/article/2015/09/04/us-markets-global-bonds-analys...
Investor flight from U.S. stocks fails to lift bond market
NEW YORK | By Gertrude Chavez-Dreyfuss
The "flight to safety" into bonds many expected when U.S. stocks slumped last week never took off, making big losers out of prominent fund managers and further confusing investors at a volatile time in the market.
Stocks plunged in the second half of August, largely on fears of China's worsening economy, but U.S. Treasury yields did not see the kind of safety bid that many were expecting and has been typical in times of stock-market stress in the past.
Strategists link the lack of a move to bonds to a number of events: Hawkish rhetoric from Fed officials even as the equity market stumbled; a bout of selling by hedge funds that had expected a rally in the bond market that they didn't get; and bond sales by central banks in China and other emerging market economies trying to protect their currencies from depreciating.
Reduced appetite from overseas, along with the outlook for the Fed, will be crucial in coming weeks if equities fall again and bonds don't respond. The Fed decision on September 17 could mark the first rate increase in almost a decade, and uncertainty surrounding that decision is likely to keep many in the bond market on the sidelines.
"The correlation between bonds and stocks is more situational now because it's the central banks calling the shots," said Robert Vanden Assem, head of developed markets investment grade fixed-income at PineBridge Investments in New York.
During the recent U.S. stock market sell-off in the third week of August, for instance, the S&P 500 .SPX dropped 9 percent, but U.S. 10-year Treasury yields, which move inversely to prices, fell by only 12 basis points.
That's not typical. According to Bank of America Merrill Lynch, the relationship between stocks and bonds that has held since 2009 suggests 10-year yields should have declined by 22 basis points.
Bond yields since then have drifted higher and buying interest has been minimal. The lack of a rally in the U.S. Treasury market made big losers out of notable hedge funds, including Bridgewater Associates' All-Weather Fund, which fell 4.2 percent in August.
These funds borrowed heavily to augment their returns, but as things became turbulent, that leverage generated losses that forced them to wind down that borrowing.
Strategists say part of what kept Treasury yields from reflexively falling through a run to safe-haven debt were hawkish signals from the Fed, particularly Fed Vice Chair Stanley Fischer.
At last week's central bank gathering in Jackson Hole, Wyoming, several Fed officials, including Fischer, seemed to boost the odds on a rate increase if not in September, then certainly in December. The message the Fed delivered over the weekend came between a Friday and Monday that saw the U.S. Standard & Poor's 500 lose 7 percent of its value.
Leading brokerages, including Citigroup and Bank of America, commented that though it's a close call, the odds favor an increase in the next few weeks.
"Unless the U.S. economy shows signs of slowing, the bond market is likely to keep yields relatively firm," said Alan Gayle, director of asset allocation at RidgeWorth Investments, even if the S&P 500 falls in the weeks ahead on concern about growth in China and other emerging market economies, he said.
Interest rate futures this week saw a more than 50 percent chance of a rate hike in December FFZ5 and a 28 percent probability in September FFU5, according to CME Group's FedWatch program.
If that happens, bonds won’t look as attractive. Higher interest rates diminish the value of an investor's bond holdings, resulting in lower portfolio returns.
"Treasuries have been a good diversifier to portfolios, but their benefit as a diversifier has been reduced because yields are already extremely low and the Fed is starting to normalize rates," said Rick Rieder, chief investment officer of fundamental fixed income at BlackRock in New York.
CHINA, CURRENCY INTERVENTIONS
Further supporting yields on U.S. Treasuries was the sell-off in reserves by China and other emerging market economies to shore up their slumping economies. U.S. Treasuries represent the bulk of the Chinese and emerging market reserves.
Fears over weakened growth prospects and plunging commodity prices in some emerging markets have taken a toll on their currencies. As China sold currency reserves in recent months, real yields have moved higher since the beginning of the year, while inflation expectations have declined.
China and emerging markets led the build-up in global foreign exchange reserves following the 1997 Asian crisis to a peak of $12 trillion last year. This cash pile shielded them from the 2007-08 crisis, and it looks as if it is once again being deployed.
It's not clear whether China has sold U.S. Treasuries over the last month, or if so, how much. Bank of America Merrill Lynch speculated in a research note that if China sold between $7 billion to $10 billion a day of U.S. Treasuries in the three weeks since the Chinese yuan devaluation on Aug. 11, it might have dumped as much as $150 billion in U.S. government bonds.
These are large numbers given the fact that the total net issuance of Treasuries this year will only be about $500 billion, said Bank of America Merrill Lynch in its research note. As of June 2015, China held $1.27 trillion in U.S. Treasury securities, according to capital flows data from the U.S. Treasury Department.
"The presence of central banks within our markets is over-riding and it's all-encompassing and has driven the activity since 2008," said PineBridge's Vanden Assem.