As a follow up to my previous article reporting that foreign buyers of US Treasuries are surging, let’s now look at the fact that foreign central bank purchases of US bonds are significantly drying up.
The landscape of US Treasury investments is witnessing a notable shift, primarily driven by foreign central banks.
Traditionally viewed as the epitome of safe investments, US Treasuries are now being questioned by these major global players due to several emerging risks.
These include the US government’s tendency to impose sanctions, its growing deficits, and the persistent inflation crisis.
Looking ahead, the US Treasury Market is transforming into a highly speculative (volatile) environment.
Since early 2022, the increase in rates from near zero to 5.5% has resulted in considerable valuation losses, particularly affecting the holdings of central banks in emerging markets.
Once seen as a risk-free asset, these bonds are now approached with caution by foreign central banks, signaling a major transformation in the global financial landscape.
Foreign Central Banks Rethink US Treasuries
Foreign central banks are rethinking their stance on US Treasuries.
It’s hardly surprising to see them exit. Holding US bonds comes with significant risks. The US government’s propensity to use sanctions to freeze assets poses a clear danger.
Yet, this is just the surface issue. Deeper concerns revolve around the burgeoning US deficits, the never-ending inflation crisis, and the Federal Reserve’s loosening grip on the treasury market.
While foreign investors robustly continue to purchase US Treasuries, central banks are showing a diminishing interest.
Foreign central bank holdings are, at best, stagnating and, in reality, being offloaded.
This leads to a pressing question: why are central banks abandoning what was once deemed the world’s risk-free asset?
What Implications Does This Have For The Future Of US Bonds?
Central banks typically seek stability in their investments. A 10-year Treasury bill is expected to maintain a consistent value. However, the last two years have seen a stark reversal.
Since early 2022, the Federal Reserve hiked interest rates from near zero to 5.5%, causing significant losses for central banks on their bond holdings.
The inverse relationship between interest rates and bond values is critical here. As the Fed combatted inflation, the value of US Treasuries plummeted.
US 10-Year Bond Values Have Collapsed by 40% Since 2022
According to Fidelity, a 1% hike in interest rates can decrease the value of a 10-year Treasury by 9%. A 3% increase could lead to a 27% crash.
What happens with a 5% hike? A catastrophic collapse in bond prices of over 40%.
Ironically, this turmoil coincides with a time when central banks, particularly in emerging markets, desperately need US dollars.
As interest rates soar, so does the dollar, forcing central banks to defend their local currencies. In this scramble, many governments incur substantial losses by selling their Treasuries, wiping out years of interest payments.
The Fall In Treasury Holdings Of Central Banks Is Evident
Since 2022, there’s been a noticeable value drop (loss) in foreign central bank US Bond holdings.
November alone saw a loss of almost $50 billion in Treasury holdings by central banks. The instability in value poses a significant risk for future investments.
The chart below shows that, since 2008, Treasury holdings by foreign central banks have plummeted from over 40% to under 15% this year—a clear indication of a major shift away from what was once considered a risk-free asset.
The Dangerous New Buyers of US Treasuries Filling the Gap
The landscape of US Treasury buyers is undergoing a dramatic change, with significant implications for both the US and the global economy. The two traditionally largest and price-insensitive buyers of US Treasuries – the Federal Reserve and foreign central banks – are either scaling back or selling their holdings.
This shift leads to a precarious situation where new buyers are emerging to fill the gap.
These include banks, pension funds, and retail investors, all of whom are highly price-sensitive.
This sensitivity spells trouble for the stability of the US Treasury Market. Inflation in the US could easily surpass the yield of a 10-year or 30-year bond, even if held to maturity.
This scenario presents a significant risk of loss, either through inflation outpacing yields or the government effectively defaulting by inflating away its debt.
Consequently, new buyers demand higher yields to compensate for these heightened risks. The new buyer base is poised to demand substantial premiums to finance Washington’s spending habits.
With the best buyers withdrawing due to Federal Reserve and government policies, the world’s largest bond market is now facing significant turmoil.
This situation is exacerbated by the ever-increasing supply of US Treasuries.
Two decades ago, the Treasury debt outstanding was only $3.6 trillion, but as of December, it ballooned to $26.4 trillion.
With deficit spending on the rise, more bonds are issued, and traditional buyers like central banks are retreating.
In their place, bargain hunters and speculators emerge, demanding higher yields and showing readiness to offload their bonds without hesitation.
Market speculations, such as the anticipated Federal Reserve rate cuts, further complicate the situation. With inflation resurging, investors are becoming increasingly wary.
For instance, JP Morgan clients significantly reduced their long bets on US Treasuries, dropping from nearly 40% in November to just 20%. This shift indicates growing speculation in a market traditionally characterized by stability.
Looking ahead, the US Treasury Market is transforming into a highly speculative (volatile) environment.
As a result, we can expect two things: bond yields, and by extension, real economy interest rates, to decline more slowly than anticipated, unless a recession occurs.
Additionally, the era of zero interest rates is effectively over.
With the best buyers withdrawing due to Federal Reserve and government policies, the world’s largest bond market is now facing significant turmoil.
Supporting article: https://www.reuters.com/markets/us/foreign-central-banks-think-twice-us-treasuries-mcgeever-2024-01-23/
