In response to Trump’s shocking announcement of a global trade war (which may have been “born out of anger at other simmering issues and the result of a broken internal process”), the age-old question has once again returned front and center: will foreigners retaliate by selling US securities?
First a quick recap: there was $6.3 trillion in US Treasuries held by foreign nations as of Dec. 2017, of which over $4 trillion was held by official accounts: central banks, reserve managers, sovereign wealth funds, and others.
Also recall that much if not all of these official foreign Treasury holdings built up over the years as US trading partners converted dollars from persistent American trade surpluses into US debt.
Which is why, as Reuters’ Richard Leong writes, should China, Japan and other nations, which have recycled their trade dollars through their Treasuries holdings, suddenly decide to whittle them down, “markets could be in for a rough ride.”
Naturally, foreigners are well aware of the volatility-inducing leverage they have, and have previously threatened to sell US Treauries in response to adverse US policies: in April 2016, it was the Saudi Arabia who Threatened to liquidate its Treasury holdings if Congress probed the country’s role in the Sept 11 attacks (Congress did, found the Saudis responsible, yet neither has Saudi Arabia “liquidated” its holdings, nor has the nation been found guilty of terrorism in any court of law, in any jurisdiction). Then in early January, Bloomberg reported that Chinese officials would recommend “slowing or halting”, or evening selling, US Treasuries (China subsequently denied the report as “fake news”).
Nonetheless, “the threats are real,” said Kristina Hooper, Invesco’s chief global market strategist. “We need more foreign demand, not less.” She is right: a foreign retaliatory move in the wake of Trump’s first big protectionist action, would come at a time when foreign demand for U.S. debt is seen critical to offset an expected surge in federal borrowing needs.
To be sure, it is unlikely that Beijing, Tokyo and other overseas central banks would dump Treasuries altogether, if at all: after all such a move would be tantamount to mutual assured destruction as the financial health of the entire world is closely tied to not only the viability of the dollar, but the stability of US rates. While China may be tempted to “teach America a lesson” by selling some of its TSY holdings, the recession that would result would lead to a plunge in US demand for Chinese exports, far worse than any trade war Trump can unleash. As a result, countries could also wind up torching their own U.S. bond investments, without winning any guaranteed gains from Washington, analysts told Reuters.
“They already own a lot of them. They would be shooting themselves in the foot,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management in Philadelphia.
Still what U.S. trading partners might do with their collective ownership of Treasury securities looms as a hefty risk not only for the bond market.
That said, foreigners don’t need to liquidate everything or even a majority of their holdings: all they need to do is engage in a sharp, acute selloff which sends yields sharply higher which – as events in early February showed – would also likely led to a stock market crash. And with Trump increasingly grading his performance by the daily moves in the S&P, a sharp market drop may be all foreigners need to accomplish to force Trump to reverse.
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What happens next is unclear: the debt market had a seesaw response on Thursday and Friday with investors firstly buying U.S. Treasuries as a safe haven and sending the 10-year yield to a three-week low. This abruptly reversed on Friday, mostly due to worries that the Bank of Japan might exit its ultra-loose monetary policy. Investors also sold to make room for next week’s heavy corporate debt supply, and the 10Y yield closed Friday near session highs, just shy of 2.87%.
However, growing anxiety among traders about foreign retaliation through selling or buying fewer Treasuries may be coming into play, some investors and analysts said. “You can’t rule it out. It’s unsettling the market a bit,” McIntyre said.
For now, the data shows somewhat mixed indications, On one hand, the latest TIC data showed that while China had been buying Treasurys in the past year…
… Japan, of all countries, had been selling.
Meanwhile, a separate data set from the NY Fed showed that as of the latest week, Treasury securities held in custody at the Fed just hit an all time high of $3.079 trillion.
Yet while on the surface there appears to be no change in foreign appetite for US paper, there is a footnote: as Bloomberg noted on Friday, the share of US Treasurys held by foreign central banks (and the Fed) has steadily declined as U.S. debt increases. Their combined share has declined to 40% from 45% in 2015. The U.S. is increasingly relying on private investors, domestic and abroad, to soak up the debt.
What it means, according to Bloomberg, is that term premium will increase as price-sensitive investors make up a larger market share. That suggests that yields are more likely to rise than fall in coming months and quarters.
And as yields rise, and dollar funding conditions get tighter (as a result of the blowing out Libor-OIS spread) making hedging of TSY purchases increasingly more costly, foreigners may have no choice but to dump US paper, whether or not in retaliation to Trump.
The question then is whether the Fed will give up all pretense of an economic recovery and do with it has always done when faced with an insurmountable US capital flow problem: unleash QE and monetize the deficit.
In other words – while it remains to be seen if foreigners dump US Treasuries in angry retaliation, it is safe to say that as of this moment, the fate of the Trump administration is in the hands of the Federal Reserve.