The biggest buyers of U.S. Treasurys have turned fickle on U.S. debt, just when they may be needed most.
Peter Boockvar, chief market analyst at The Lindsey Group, points out that for a fourth month in a row, foreigners were net sellers of U.S. notes and bonds, dumping $13.1 billion in July for a year-to-date total of $156 billion.
That compares to net selling of $20 billion for all of 2015, but foreigners made massive purchases of about $1 trillion in total for the four years prior to that.
“This level of selling is unprecedented,” he said. And it comes just as U.S. interest rates may have seen their cycle lows and bond yields look set to rise.
“This is the fragility beginning to rise in Treasurys and global sovereign bonds,” he said.
Central bank bond-buying programs — or quantitative easing — have been the key factor driving yields to record lows. That has been blamed for creating a bubble in global bond markets, and Boockvar said there are signs the air is starting to leak out.
“We’ve all been trading together. It’s been one big sovereign bond trade essentially,” he said.
U.S. Treasury yields fell as Japan’s 10-year yields went negative and German bund yields sank. But reversals in those interconnected markets helped drive Treasury yields higher, and prices lower.
QE is testings its limits, and even European Central Bank PresidentMario Draghi has said he is running out of bonds to buy. Draghi also disappointed the markets recently when he did not provide a clear promise to extend the ECB’s QE program at its last meeting.
Now that QE could be about to slow down or even reverse, the U.S. market could become more vulnerable to this lack of foreign buying, Boockvar said.
A key factor that could turn the tide for sovereign debt yields is the Bank of Japan, which meets Tuesday and Wednesday, and may decide to stop buying longer-duration bonds, according to reports.
That should steepen the yield curve, meaning long-end rates would rise more than short-term rates and the spread between them would then widen. A steeper yield curve is seen as a positive for banks and other financial institutions.
“There’s a global recognition that you need a healthy banking system to have a strong economy,” he said.
Whatever the BOJ does could certainly influence rates globally. U.S. rates hit super-low levels, as investors loaded up on Treasurys in the face of lower and negative yields in Europe and Japan, and if long-end rates rise in those regions, investors could dump Treasurys.
Besides the Bank of Japan as a factor, the Fed is leaning toward raising rates even though it is not expected to take action at its meeting — also Tuesday and Wednesday. Most Fed watchers see December as the next time the U.S. central bank would hike rates.
Boockvar said the capital flow data show selling has come from foreign central banks, while foreign private buying has been positive. “Our largest holder, China, was a net seller of $21 billion of notes and bonds after selling $28 billion worth in June. They, of course, are slowly bleeding reserves. Japan our second-largest holder was a net buyer of $3.6 billion after selling $13.2 billion in June,” he said.
If the foreigners remain on the sidelines, Treasury yields could move up faster regardless of Fed policy. There is also the potential for fresh fiscal spending programs next year, when a new president is in the White House and is eager to boost economic growth. To fund those programs, the U.S. would need to issue more debt which could also send yields higher.
“Bottom line, a major crutch for the U.S. Treasury market over the past decade of foreign central bank reserve accumulation has gone away for now,” Boockvar said. China is an outright seller of Treasurys, because it is seeing capital outflows and its economy is slowing.
“Foreign flows were a big part of Treasury bond buying. Take that away and central banks take away the stimulus that was affecting long-term interest rates. Deficits are expected to head higher. This is a process that takes time to see these things play out,” he said.
Before last year’s selling, foreigners were net buyers of $165 billion in Treasurys in 2014; $41 billion in 2013; and $400 billion in each of 2011 and 2012, Boockvar said.
“What is important is the shift at the Bank of Japan,” he said. He said the Fed started quantitative easing, or bond buying, but the Japanese bank ran with it. “In terms of the size of their economy, no one is doing it like Japan is. Their balance sheet is going to be two-thirds the size of their GDP,” he said.
He said the Bank of Japan’s tweaking of its QE buying would signal an acknowledgment that easing was pushed too far and it needs to backtrack.