Evolving US bondholder makeup shapes business decisions
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The composition of the investor base of sovereign bond markets is very important. In Japan, for instance, a large domestic investor base (a result of high pension savings that have a significant home bias) is broadly accepted as being a big driver of Japan’s relatively low and stable yield environment, despite high amounts of debt.

Similarly, in the U.K., long-term yields have been more stable, and the yield curve flatter than other western G7 markets, because of the influence of domestic pension companies and their accompanying regulatory frameworks. Pension regulations encourage the holding of medium-to-long dated gilts.

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Over recent years, the composition of the investor base has been thrown into sharper relief by quantitative easing strategies and repression of official interest rates by central banks. Japanese, U.K., U.S. and European sovereign bond yields have been significantly affected because of this.

 

Also of increasing interest has been the influence of non-resident investors, driven by the size of China’s U.S. Treasury exposure. Regression analysis by the International Monetary Fund (IMF) shows that the share of securities held by non-residents is negatively correlated with bond yields.

An increase (decrease) in non-resident investors by 10 percent is associated with a reduction (increase) in yields between 32 to 43 basis points. The analysis also shows that volatility increases with the size of the non-resident investor base.

Volatility reflects uncertainty. The greater the uncertainty about how short term interest rates will evolve, the more difficult it is for banks and companies to plan and invest for the future, particularly if volatility of short-term Treasuries influences longer maturities. This would act as a restraint on economic activity. It will also have implications for the government’s fiscal planning, both the cost and maturity of the debt. 

China’s holdings of U.S. Treasuries increased steadily over time as the Chinese authorities invested their accumulated foreign exchange (FX) reserves into the bond markets of reserve currency issuers, the U.S. being the largest. By 2015, official data showed that China held nearly $1.3 trillion in U.S. Treasuries.

The weakening of the Chinese currency (which began in early 2014 as internationalisation of the renminbi began to be debated more broadly) started to accelerate in mid-2016. This brought a response from the Chinese authorities to control the weakness through FX intervention, resulting in the need to sell U.S. Treasury holdings, such that Chinese holdings of U.S. Treasuries are now close to $1 trillion.

Central bank holdings of foreign sovereign debt tends to be in short maturities, so any selling of U.S. Treasuries by China will likely have been at the front end of the curve. There has been a concern, therefore, that with the Federal Reserve on a tightening path (and potentially ending reinvestments of QE holdings) the short end of the U.S. yield curve could experience higher volatility, particularly if the capital outflows that China is battling get worse.

Capital outflows have created a dilemma over whether China should defend its fast-draining foreign exchange reserves or let the renminbi (RMB) fall at the hands of market forces. The question then extends to how far China’s FX reserves can drop before the markets start to react more aggressively.

From their peak in mid-2014, Chinese reserves have lost about $1 trillion to stand at roughly $3 trillion at the end of 2016. The pace of the reserves depletion in 2016 was about $25 billion per month and, based on our estimation, speculative outflows averaged some $95 billion per month.

From a simple safety-net perspective, it is desirable for reserves to cover at least six months of imports, which for China adds up to $1 trillion. For one year, to provide a larger cushion, it would be $2 trillion. 

The IMF has more extensive yardsticks for reserves coverage, such as the M2 money supply-to-reserves ratio. This measurement helps to check the risk of dollarization of the financial system, whereby local residents and corporations lose confidence in their currency and prefer holding the U.S. dollar instead. The estimation for China in this methodology would be $1.6 trillion for the minimum coverage, and $2.6 trillion for a more conservative cushion. The midpoint is also around $2 trillion. 

So there is scope for further selling of U.S. Treasuries by China. However, concerns over the impact on U.S. yields should be tempered by the following: first, the Fed tightening path has, to a large extent, now been priced into the short end of the U.S. yield curve, so the recent experience of Chinese Treasury sales combining with the Treasury market pricing in higher rates will not likely be repeated.

The Fed has also indicated that reinvestment of U.S. Treasuries from their QE program will not begin for quite some time, perhaps years. Second, stability in the oil price has seen Middle East reserve asset flows rebound. Third, the largest holders of US Treasuries, Japan: continue to make large purchases of Treasuries (USD 130 bn in 2015 and USD 163 bn in 2016). Fourthly, Chinese FX reserves are not solely comprised of government bonds.

In order to avoid concentrating risks and higher volatility in its reserves, China will need to start selling assets of relatively low quality, such as real estate. Indeed, if reserve selling gets too aggressive then concerns will spread to other markets, which could provide a risk-off feedback loop that would support Treasuries.

 

Daniel Loughney is a fixed income portfolio manager for AllianceBernstein, an asset management company. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.


 

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