The tug-of-war over US Treasuries

Peter Warburton - 30 August 2018

A fascinating tussle is developing in the US Treasury bond market, where the 10-year yield is oscillating in the range 2.75 per cent to 3 per cent. Bond bulls argue that the global economic expansion is long in the tooth, the yield curve is flattening, signalling the end of the tightening cycle, and that the US bond offers an internationally attractive yield. Our retort is that US and global inflation is still rising, that the supply-demand balance in government debt instruments is set to deteriorate and that the US economy is undergoing a nominal acceleration that requires and presumes a higher level of interest rates across the curve. Indeed, the adaptation of government bond yields to their nominal economic environment has been a reliable feature of the data for more than 50 years.

To gain a sense of the protagonists and antagonists in this struggle, it is helpful to refer to the monthly TIC data. While its geographical allocations are subject to various distortions, including custodial veils, and the data is not as timely as we would wish, it provides a starting point for our analysis.  US government bonds are held by the official and private sectors around the world, so it is possible to infer the motivations that underlie the strikingly different patterns of net acquisition by countries and regions. As of end-June, the strongest rolling net acquisitions of US Treasuries were channelled through the UK and France (figure 1). These flows are probably a blend of UK- and French-based investment funds flows and redeployed Middle Eastern inflows (which tend to be correlated with oil prices). The cumulative annual flows from the UK peaked at US$211bn in April.  China’s enthusiasm for US bonds has recovered to a broadly neutral position over the past year, but it is possible that part of the offsetting outflows via Benelux are Chinese in origin.   

What stands out from this analysis is that most of the net foreign flows that currently support T-bond prices (figure 2) look to be private investor-based (UK, Latin America, Caribbean and Channel Islands) while the net flows that undermine bond prices have overtones of official motivation (e.g. India, Russia and Japan).  Russia, under threat of US sanctions, is unlikely to be reinvesting in US Treasuries anytime soon (figure 3). Other nations, even Japan, must be unsettled by the quixotic behavior of the US president to other sovereign countries. In extremis, the US holds the power to freeze foreign assets held in custody by the Federal Reserve Bank of New York. Whereas the investment funds alternate between bullish and bearish positioning in the US debt markets, elsewhere there is more than a hint of structural divestment.

Much rests on the credibility of the intellectual framework around the US natural rate and the anchoring of the so-called terminal Fed funds rate. There is a decent chance that US de-regulatory and expansionary fiscal policies will blow this cozy market consensus right out of the water, paving the way for a disorderly rise in US 10-year and 30-year Treasury yields. The extremely bearish net speculative positions in US Treasuries (figure 4) suggests that we are not alone in this concern. As president Trump gears up for the mid-term elections and re-focuses from tariffs to tax cuts and infrastructure spending, the risks are tilted to the higher yield scenario.   

Figure 1

Data source: US Treasury International Capital dataset

Figure 2

Data source: US Treasury International Capital dataset

Figure 3

Data source: US Treasury International Capital dataset

Figure 4

Data source: CFTC

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