Why have nations fallen out of love with US Treasury bonds?

(c) Sky News 2018: <a href="http://news.sky.com/story/why-have-nations-fallen-out-of-love-with-us-treasury-bonds-11474172">Why have nations fallen out of love with US Treasury bonds?</a>
 

It's the world's safest and most actively-traded financial instrument - and essential in meeting the US government's voracious and ever-increasing appetite for borrowing.

Yet it seems some international investors have fallen out of love with US Treasury bonds.

Figures released late on Wednesday reveal that China and Japan, respectively the two largest holders of US Treasuries, were offloading the bonds during June - the latest month for which figures are available.

China sold $4.4bn (£3.5bn) worth of treasuries during June and its holding has been cut by some $138bn - a sum equivalent to Hungary's entire economic output - since it peaked at the end of 2013.

Japan, meanwhile, sold $18.4bn worth of treasuries during the month. It now holds less US government debt than at any time since October 2011.

It follows heavy selling by some other countries during recent months.

Russia has offloaded almost all of its holdings of US Treasuries since March this year in a move that mystified the market although it was not a seller in June.

Its holdings of US debt have fallen from a peak of $176.3bn in October 2010, when it was America's sixth-largest foreign creditor, to less than $30bn - below which holdings are not disclosed - today.

And it emerged yesterday that Turkey was also selling heavily during June. Its holding of US Treasuries has fallen by 42% during the first half of the year.

Both Russia and China have been switching into other assets, including gold, which now makes up more than a sixth of Russia's entire foreign reserves.

Overall, foreign investors were net sellers of US Treasuries in June, offloading $48.6bn worth of the securities - although buyers during the month included Brazil, the UK, Saudi Arabia, France and Belgium.

The selling has led to speculation that investors in some of these countries have been selling in response to Donald Trump's aggression towards them.

Mr Trump has ratcheted up pressure on both China and Russia during recent months, slapping tariffs on $50bn worth of Chinese goods and imposing sanctions on various Russian government officials and oligarchs with close ties to President Putin in retaliation for Russia's interference with the 2016 US Presidential elections, its occupation of Crimea and its supplying of weapons to the brutal Assad regime in Syria.

Turkey, meanwhile, has been dragged into an expensive tit-for-tat round of tariff impositions with Washington following its jailing of an American pastor for his alleged involvement in the 2016 coup attempt.

All of this would make a certain amount of sense were it not for the selling by Japanese investors.

Japan has little reason to hold a grudge against Mr Trump other than the fact the its prime minister, Shinzo Abe, was kept in the dark about the President's sudden decision to meet North Korean leader Kim Jong-un.

The theory here is that Japanese investors have been rotating out of treasuries into other, more risky, US assets that pay a greater return.

The yield on 10-year treasuries currently stands at 2.8623% and the yield on 30-year treasuries - known in the market as the 'Long Bond' - stands at 3.0287%.

That is a higher yield than that offered by the Japanese equivalent, which currently stands at 0.1% and 0.851% respectively, but can be improved on by any number of other financial assets.

However, not only is such a low rate of return exposed to inflation, any extra return made by switching from Japanese to US bonds can also be eroded by the cost of hedging against moves between the yen and the US dollar.

When those costs rise, as they have been, it obliges Japanese investors to look at other assets. Moreover, holding US Treasuries has been a loss-making trade during the first half of the year for Japanese investors, regardless of whether they hedged or not.

Why does this matter?

A couple of reasons.

First (Other OTC: FSTC - news) of all, America's borrowing continues to pile up. US national debt stood at $21tn at the end of April while the budget deficit, the difference between what the US government spends and what it receives in tax receipts, is expected to hit $1tn by 2020. So America needs the rest of the world to carry on buying its IOUs.

Secondly, if America is forced to respond to a shortage of buyers for its treasuries by paying bond investors a greater return, it would have 'real world' consequences in the form of higher borrowing costs for American households and businesses.

Jamie Dimon, chief executive of JP Morgan and one of the most influential figures on Wall Street, said earlier this month that 10-year yields should currently be 4% and that investors had "better be prepared to deal with rates 5% or higher".

There is probably no need for the US Treasury to panic just yet: the US Federal Reserve has raised interest rates seven times in the last three years while the European Central Bank persists with a negative overnight deposit rate and is unlikely to raise the cost of borrowing any time soon.

The spread between the yield on US Treasuries and the yield on German bunds, a comparable financial instrument, is at its highest level for nearly three decades - offering German investors a profitable and relatively risk-free trade.

However, if there is a big change in the balance between supply and demand for US Treasuries looming, it could point to awkward times ahead.