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.