It's not just stocks have a terrible start to the year, in fact the worst start in history: so is the amount of US Treasuries held in custody at the Fed, a direct proxy for the holdings of foreign central banks, reserve managers and sovereign wealth funds who park owned TSYs at the NY Fed for convenience.
According to the latest Fed data [12], after a drop of $12 billion in the first week of the year, another $34.5 billion in Treasuries held in custody was sold in the week ended January 13, bringing the total to just $2.962 trillion, below the previous recent low recorded in early November, and at levels not seen since April 2015.
Indicatively since April, total US Treasury holdings have increased by $570 billion, meanwhile not a single incremental dollar has ended up in the Fed's custody account.
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As shown in the chart below, the drop recorded in the latest period is the single largest weekly drop recorded since China commenced liquidating its Treasury holdings in mid 2014.
[14]
Adding up the flows from the first two weeks of the year reveals the worst and most custody holdings "outflowing" start to the year in history.
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The size of the liquidation promptly got the rate community's attention.
On Friday afternoon, MarketNews cited Louis Crandall, chief economist at Wrightson ICAP, who said "we have seen declines of more than $20 billion (in such Treasury custody holdings) on each of the first two weeks of this year. While accounts are volatile from week to week, that is certainly consistent with increasing intervention activity" from foreign central banks needing money to intervene either in the foreign exchange market or in the stock market, he said.
"There is no way of knowing" exactly what such central banks sold, he added. "But it could just as easily have been liquidation of coupon securities."
As MNI further writes, most observers saw China selling as behind the drop in Treasuries holdings at the Fed. "Circumstantially, that's the conclusion that people would jump to," said Crandall.
Some said it is not just China: Aaron Kohli, analyst at BMO Capital Markets, was less inclined to point to China. "It's definitely a drop, but keep in mind, every foreign central bank is in there," he said.
One other observer said that the decline "should be foreign central bank selling" as opposed to routine rolling of maturing securities. "Those are very chunky numbers. We did not even get such large sales back in August 2015 when we knew there was such selling" in Treasuries to get money to fund buying of China stocks, he said.
Others, however, disagree: "That kind of size could only be China," said the observer. But he added that at the margin, other Asian central banks could have been selling Treasuries to raise dollars for foreign exchange or stock market intervention.
One trader said China "must be selling, along with others. Look at the Hong Kong dollar, also down big. It is a game of musical chairs, and everyone is devaluing at once. The U.S. dollar strength is apparent."
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One trader who has put all this together, and has linked it to the abnormal moves in the Treasury swap market is Ice Farm Capital's Michael Green.
As he puts it, "those who chose to seek protection in rates are only experiencing middling success due to the continued inversion of swap spreads which have traded to record highs."
Now this has been repeatedly noted in the press as irrational – why would US government bonds be trading at a risk premium to swap spreads which carry bank counterparty risk? I would suggest there is one very simple reason:
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His conclusion is that "swap spreads appear to be blowing out because foreign holders of treasuries, namely China, are selling them at a record pace to defend their currencies. Currency levels are under attack in China, Saudi Arabia and now Hong Kong. The specter of 1997-1998 is again haunting the markets."
As Green frames it, "the key question is “How long can this go on for?” Consensus is clearly that China, in particular, has a deep pool of reserves with which to defend their currency; I am less convinced. Having seen some contrarian work on the subject, my belief is that China is a paper tiger – with very little reserves left to defend their currency. Perhaps as little as three months given their current burn rate."
If accurate (and Green's calculation excludes the hundreds of billions China may need to leave on its books if its NPL credit cycle finally hits as Kyle Bass is currently anticipating) then the coming months could see an unprecedented shock out of China which having spent hundreds of billions to slow a record capital outflow, has no choice but to let its currency finally float freely, leading to the biggest capital exodus in recorded history.
