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
