23 July 2018

Foreign Investors Lose Hunger For U.S. Debt

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Foreign investors’ appetite this year for U.S. debt hasn’t grown at the same pace as the government’s borrowing needs, which some analysts worry could push bond yields higher and eventually threaten to slow economic growth.

Investors in a broad category known as “indirect bidders,” which includes both mutual funds and foreign investors, have been winning the smallest percentage of the bonds they’ve bid for since 2011, according to bidding data for recent Treasury bond auctions. The average percentage of the auctions won by this group fell for the first time since 2012, a decline some analysts attribute to both lower demand from investors outside the U.S. and their recent tendency to post less-aggressive bids.

The behavior of these bidders is crucial for the ability of the U.S. to fund itself, at a time when the budget deficit is forecast to surpass $1 trillion by 2020 and remain above that level for the foreseeable future. Foreign investors currently hold about 43% of U.S. government debt, the lowest since November 2016, a proportion that has steadily declined from its peak of 55% during the 2008 financial crisis.

The decline in foreign demand comes as the yield on the 10-year U.S. Treasury note—a benchmark used to help set the interest rates for mortgages, credit cards and business loans—hit 3% last week for the first time since 2014. Many investors and analysts expect yields to climb further as the increase in U.S. borrowing due to tax cuts and higher spending expands the supply of debt outstanding. Higher borrowing costs could eventually become a drag on economic growth, increasing the potential for a slowdown in the long expansion.

While the percentage of Treasurys held by foreign investors has declined, such buyers remain crucial to the bond market, holding roughly $6.3 trillion of government debt. Even simply rolling over maturing bonds at the auctions requires foreign investors’ participation. They have bought at least 17% of government auctions each year since 2014, maintaining their support for the primary market during a period where the share purchased by bond dealers has consistently declined.

“We cannot exist at these growth rates with these deficit projections without foreign participation,” said Andrea Dicenso, a portfolio manager and strategist at Loomis, Sayles & Co.

Demand for Treasurys from foreign investors has experienced a number of ebbs and flows over time, but the securities are enmeshed in globe-spanning financial relationships that serve to mute the impact of any one group, from central banks to broker-dealers. While some investors have expressed concerns that China could sell a significant block of its holdings, flooding the market with Treasurys at a period where the U.S. is increasing new-issue sales, economists and other investors argue such a move would run counter to China’s own economic interests.

Foreign holdings of Treasurys rose last year for the first time since 2014, keeping pace with the increase in government debt outstanding. In February, they climbed to $6.29 trillion of the $14.7 trillion of then-outstanding U.S. government debt, the Treasury said April 16, up from $6.26 trillion the prior month.

China’s holdings rose by $8.5 billion to $1.18 trillion while, Japan’s fell by $6.5 billion to $1.06 trillion.

The gains last year notwithstanding, a persistent shift in bidding would represent a crack in the mechanisms through which the Treasury has funded its operations through periods of both prosperity and crisis.

While auction data on “indirect bidders” doesn’t break out which components of the broader category bid at what levels, extrapolating from trading during Asian and European market hours points to weaker bids from foreign investors, said Jim Vogel, head of government bond strategy at FTN Financial.

Foreign investors are probably going to be slower to adjust to the expansion of U.S. borrowing because “they have limited flexibility in terms of how many dollar investments they can make,” Mr. Vogel said.

A separate set of Treasury figures known as allotment data shows foreign demand fell below its five-year average in March, after rising to a 21-month high in February. And the backdrop for this year and the foreseeable future is more challenging.

The rise in government borrowing is happening at the same time the Federal Reserve is reducing its Treasury debt holdings. Some analysts think the Fed could continue to allow its Treasury bond portfolio to shrink to half its $2.4 trillion size, reducing a steady source of demand. It’s also occurring at the same time the Trump administration is taking an increasingly confrontational approach to the U.S. trade relationship with China, which is the largest foreign holder of Treasurys.

A weak dollar is also making it more difficult for some overseas investors to buy Treasurys by making it more expensive to hedge currency risk. While this is less of a problem for investors willing to bet on the greenback and for foreign central banks that buy the debt to weaken their own currencies, some investors have opted to buy European or Asian government debt instead.

Even as investors and analysts remain concerned about the level of foreign demand proliferate, global economic linkages and international trade create strong incentives for foreign investors to continue to buy Treasurys. Major exporters such as China and Japan, which are also the biggest foreign lenders to the U.S. government with a combined $2.23 trillion of its debt, have their own motives to lend to the largest customer for their exports and to keep their interest rates down, said David Ader, chief macro strategist at Informa Financial Intelligence.

“It behooves them to underwrite our debt because if we’re in a recession or worse, it would hurt their economies as well,” Mr. Ader said.

Click here for the original article from The Wall Street Journal.

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