Recent articles in the financial press have stressed how foreign official institutions (i.e., central banks and sovereign wealth funds) have been selling large amounts of U.S. Treasuries to counter currency depreciation pressures (in Asia and Latin America) or to finance large budget deficits (Middle East/oil producing countries) no longer sufficiently financed by oil revenues. Commentators argue that a continuation of this phenomenon could lead to further outflows from U.S. Government bonds and a sharp increase in long-term U.S. bond yields.
We don’t subscribe to this logic. In our opinion, the argument fails to recognize “the other side of the trade.”
Indeed, foreign official institutions have been selling U.S. Treasuries in record amounts throughout 2015 ($200bln over the 12 months ending 11/30/15). However, U.S. bond yields have remained largely unchanged despite a Fed tightening bias, a U.S. recovery, and the first rate hike in nearly 10 years. Why?
Stating the obvious, for every seller there is a buyer. In this case, it means that the buying was robust enough to offset the selling pressure from official institutions without causing a meaningful rise in interest rates. So who was on the other side? And what was their motivation for buying U.S. Treasuries? The chart below clearly shows that record sales of U.S. Treasuries by foreign central banks were matched by sizable purchases from foreign private investors. Moreover, U.S. investors have been repatriating record amounts of their foreign bond holdings, with a large share of those proceeds likely reinvested into U.S. Treasuries1.
Source: U.S. Treasury data, 11/30/2015.
Many of the economic forces leading private investors into U.S. Government bonds are related to the same factors causing central banks to sell, namely falling commodities. The sharp drop in oil prices sends deflationary waves through both the real economy and financial markets, and these forces are a powerful catalyst of additional private sector demand for U.S. Treasuries:
- First, falling oil prices lower inflation expectations and the future path for rate hikes by the Federal Reserve.
- Second, over the past decade a large share of global dollar-denominated borrowing took place in the natural resources and mining sectors, especially in emerging markets. Falling commodities have put these sectors under stress, affecting global credit and currency markets, leading to a widening in credit spreads, a stronger U.S. dollar and weaker emerging markets.
This has resulted in increased risk aversion and demand for government bonds by foreign and domestic private investors.
In sum, we believe 2015 offered a valuable template of how and why the U.S. Government bond market can be resilient in the face of record selling by foreign central banks. As long as deflationary forces remain in place, private investors should step in to take “the other side of the trade.” On the contrary, if oil prices were to sustainably rebound, coupled with rising U.S. wages, the reflationary effect would be far more problematic for U.S. bond yields. We currently attach a low probability to this scenario.
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1 Since a purchase of U.S. Treasury bonds by U.S. based investors is a domestic transaction, and not a cross-border transaction, it is not recorded under the international capital system data.↩
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