With the December monthly TIC data due out this week, bond traders will be closely watching if the selling of US Treasuries by foreign accounts, and especially central banks, which as we have repeatedly shown for the past several months has hit record levels…
… will persist, with a focus on whether China’s near record selling of US paper will persist.
However, this time the surprise may not be China, but its nemesis across the East China Sea, Japan.
As UBS notes, Japanese investor appetite for developed market overseas bonds, and especially US, was a big story during the first seven months of 2016. However, since then interest has waned. Weekly flow data underscores how Japanese investors sold ~¥4 trillion of overseas bonds from the time of the US presidential election to the end of Jan-17. Last week the Japanese government released more granular data for the month of December which highlights a number of notable developments.
Most importantly, while December saw the largest overall net selling flow of overseas bonds since Jun-15, this was entirely due to offloading of US Treasuries – other developed bond markets on aggregate actually saw modest net purchases. Indeed, while Japanese investors bought German and Australian paper, US Treasuries were sold to the tune of ~¥2.4 trillion (~$21bn) in December, the largest net selling flow since May-13.
While last month (i.e. data for November) there were several factors that supported a rebound in Japanese investor demand for overseas debt (e.g., calmer market conditions, higher overseas FX-hedged yields, and supportive seasonality in Q1, a Trump honeymoon that was still in its early stages), so far there is little evidence of any bounce back in December, when yields surged across the curve, spurring widespread sales. Reuters and Bloomberg interviews with Japanese investors suggest that US political concerns and the potential for further Fed hikes are weighing on demand. Still, the potential for reallocation flows should not be overlooked, as highlighted by today’s data.
The selling has been so acute that after ignoring it for months (we first noted the record sales last September), the relentless selling has attracted the attention of Bloomberg which writes that “the consensus is clear: few overseas investors want to step into the $13.9 trillion U.S. Treasury market right now. Whether it’s the prospect of bigger deficits and more inflation under President Donald Trump or higher interest rates from the Federal Reserve, the world’s safest debt market seems less of a sure thing — particularly after the upswing in yields since November. And then there is Trump’s penchant for saber rattling, which has made staying home that much easier.”
[A]ny consistent drop-off in foreign demand could have lasting consequences on America’s ability to finance itself cheaply, particularly in light of Trump’s ambitious plans to boost infrastructure spending, cut taxes and put “America First.” The president has singled out Japan and China, the two biggest overseas creditors, as well as Germany, for devaluing their currencies to gain an unfair advantage in trade.
Whether Bloomberg is correct – especially after a brief rebound in the amount of Treasurys held in custody at the Fed in December – remains to be seen, some of the comments Bloomberg cites are worth nothing, the first of chich comes from a bond strategist at Japan’s Mitsubishi UFJ:
“It may be more difficult than usual for Japanese to invest in Treasuries and the dollar this year because of political uncertainty,” said Kenta Inoue, chief strategist for overseas bond investments at Mitsubishi UFJ Morgan Stanley Securities in Tokyo. “Treasury yields may rise rapidly again in the near future, which will continue to discourage them from buying aggressively.”
Of course, the higher the yields go, the greater the implicit demand for yields should be, however in a world where everything is one giant momentum trade, it may take a while before it emerges.
Which is for now, other bond strategists agree with Inoue: “For now, risk-averse bond buyers like Daiwa SB Investments’s Shinji Kunibe are cutting back on Treasuries.”
Like many institutional money managers that invest abroad, Kunibe, Daiwa SB’s head of fixed-income management, likes to hedge away the risk of the dollar’s ups and downs. And right now, it makes sense. After accounting for hedging costs, 10-year Treasuries yield about 0.9 percent, roughly 10 times the return offered by Japanese government bonds. Going back to the 1980s, Treasuries have rarely enjoyed such a big edge over JGBs. However, he sees U.S. yields rising further as Trump pursues expansionary fiscal policies and takes a protectionist stance on trade. “Yields are going to be in an uptrend,” he said.
As Bloomberg puts it, investors like Kunibe can ill-afford more losses. Japanese demand for US paper first slid into the late summer as hedging costs – mostly in the form of swap spreads – rose…
… last quarter, Japanese investors who hedged all their dollar exposure in Treasuries suffered a 4.7 percent loss, the biggest in at least three decades, Bloomberg reports citing data from Bank of America showed. The same thing happened in Europe, where record currency-hedged losses also stung euro-based buyers.
“It was a deer in the headlights moment,” said Zoltan Pozsar, a research analyst at Credit Suisse.
While the yield pick up in recent weeks has made hedged positions profitable relative to JGBs once again, the Japanese are not rushing in.
Combined with the unpredictability of Trump’s tweet storms, interest-rate increases in the U.S. could further sap overseas demand. Mark Dowding, who helps oversees about $50 billion as co-head of investment-grade debt at BlueBay Asset Management in London, says the firm has already moved to insulate itself from further losses due to higher rates.
What’s more, central bankers in Japan and Europe are still experimenting with monetary policies that may benefit bond investors locally.
Right now, it’s just “much easier to stay home than go abroad,” said Shyam Rajan, Bank of America’s head of U.S. rates strategy.
Unless, of course, the BOJ, which has been experimenting with “curve control”, and nearly lost it last week, fails to maintain the long end at the desired range. Once that happens, and global bond curves become unhinged leading to a worldwide dumping of duration, it may be time to head for the exits.