Over the weekend, in its attempt to explain the sharp Treasury selloff in the second half of April which sent the 10Y briefly above 3.00%, JPMorgan cast the blame almost exclusively on momentum-chasing funds, i.e. CTAs, whose sharp momentum reversal from net long to net short...
... took place at a time when investors were already record short the TSY futures complex as we first showed on Saturday morning.
The implication was that with CTAs - which trade on nothing but pure technicals and momentum and are oblivious to fundamentals such as inflation or central bank policy, having flip-flopped twice in one month, much of the downside pressure on Treasury prices would be removed:
Given that a shift to shorts by CTAs is likely to have taken place over the past week and a half in our framework, we think that momentum traders are less likely to remain as a strong bearish force for 10y USTs going forward
But while that explanation was clear and clean enough, there was more.
As we showed last night, in addition to CTAs reportedly dumping their long exposure, someone else was busy selling: foreign central banks. To be sure, while there is no foolproof, coincident indicator of what official public accounts and monetary authorities do with their Treasury holdings, the Fed's weekly report of Treasurys held in custody is the closest thing there is to a real-time indicator. It is here where we find the biggest weekly drop in holdings since the China deval days of January 2016, which implicitly suggest that China may indeed have been liquidating at least a modest portion of its TSY holdings as many people suggested, if only tongue in cheek.
Shortly after we first published out observation last night, Bloomberg picked up on it, and in a note by Kyoungwha Kim, the Markets Live commentator wrote that "foreign central banks look to have pulled back last week when the 10-year yield breached 3%, paring their near-record holdings." Kim also noted that bank sales accelerated as hedge funds built up an unprecedented Treasuries short, as we first demonstrated on Saturday. Bloomberg's ominous assessment:
"An avalanche of selling may follow. Piling on fuel in the form of tax cuts and infrastructure spending to an already booming American economy raises the risk of inflation. Pension funds and other institutions may be the next to start selling."
It wasn't just us and Bloomberg, however, warning about the sliding foreign appetite for Treasurys. This morning the WSJ also writes that "foreign investors’ appetite this year for U.S. debt hasn’t grown at the same pace as the government’s borrowing needs, which some analysts worry could push bond yields higher and eventually threaten to slow economic growth."
WSJ focuses on another aspect of foreign demand represented in Treasury auctions, namely the takedown by Indirect Investors, which comprise mostly of foreign central banks and other official institutions:
"Investors in a broad category known as “indirect bidders,” which includes both mutual funds and foreign investors, have been winning the smallest percentage of the bonds they’ve bid for since 2011, according to bidding data for recent Treasury bond auctions. The average percentage of the auctions won by this group fell for the first time since 2012, a decline some analysts attribute to both lower demand from investors outside the U.S. and their recent tendency to post less-aggressive bids.
As the WSJ notes, "the behavior of these bidders is crucial for the ability of the U.S. to fund itself, at a time when the budget deficit is forecast to surpass $1 trillion by 2020 and remain above that level for the foreseeable future. Foreign investors currently hold about 43% of U.S. government debt, the lowest since November 2016, a proportion that has steadily declined from its peak of 55% during the 2008 financial crisis."
Declining foreign demand at a time of soaring budget deficits and funding needs, not to mention a Fed which is no longer monetizing the $1+ trillion US budget deficit is, needless to say, a major problem.
“We cannot exist at these growth rates with these deficit projections without foreign participation,” said Andrea Dicenso, a portfolio manager and strategist at Loomis, Sayles & Co.
Foreign holdings of Treasurys rose last year for the first time since 2014, keeping pace with the increase in government debt outstanding. In February, they climbed to $6.29 trillion of the $14.7 trillion of then-outstanding U.S. government debt, the Treasury said April 16, up from $6.26 trillion the prior month.
As we highlighted after the latest TIC report, China’s holdings rose by $8.5 billion to $1.18 trillion while, Japan’s fell by $6.5 billion to $1.06 trillion; however both have seen a decided move lower in recent months.
And while there is still clearly interest for US paper among foreign borrowers, it is clearly fading:
Foreign investors are probably going to be slower to adjust to the expansion of U.S. borrowing because “they have limited flexibility in terms of how many dollar investments they can make,” Mr. Vogel said.
A separate set of Treasury figures known as allotment data shows foreign demand fell below its five-year average in March, after rising to a 21-month high in February. And the backdrop for this year and the foreseeable future is more challenging.
Among other factors pressuring demands for US Treasuries is the weak dollar which is also making it more difficult for some overseas investors to buy Treasurys by making it more expensive to hedge currency risk. While this is less of a problem for investors willing to bet on the greenback and for foreign central banks that buy the debt to weaken their own currencies, some investors have opted to buy European or Asian government debt instead.
Then there is the issue of hedging: as the Fed has continued to hike rates and diverge from other major central banks, hedging costs have become more expensive for foreign investors. As shown in the chart below from Deutsche Bank, 10-year Treasuries no longer offer a yield pickup for European-based investors on a currency-hedged basis. The same dynamic is true for Japanese-based investors. This means that unless funding cost drop sharply soon, demand for US paper will only decline in the coming months.
Still, even as investors and analysts become increasingly concerned about the level of foreign demand proliferate, global economic linkages and international trade create strong incentives for foreign investors to continue to buy Treasurys according to the WSJ. To be sure, major exporters such as China and Japan, which are also the biggest foreign lenders to the U.S. government with a combined $2.23 trillion of its debt, have their own motives to lend to the largest customer for their exports and to keep their interest rates down, said David Ader, chief macro strategist at Informa Financial Intelligence.
“It behooves them to underwrite our debt because if we’re in a recession or worse, it would hurt their economies as well,” Mr. Ader said.
Yes... to a point. As Deutsche Bank pointed out in a disturbing analysis that found that the chance of a US debt funding crisis is rising, and is now the highest it has ever been outside of recession...
... there is a point after which the US debt load will no longer be unsustainable...
... as none other than Goldman warned previously.
OK, but when? Recall Deutsche Bank's conclusion:
"We cannot say exactly what level of debt (85% of GDP? 100%? 125%?) will prove to be the tipping point, but we do believe that the latest fiscal developments have increased the odds of a crisis."
Which in turn brings us back to what BofA said last week: "The 10Y Treasury Is No Longer A "Safe Asset". Soon the market may have the unpleasant experience of discovering just what that means.