Foreign central banks have become yet another worry for investors in the world’s most important bond market these days, they’ve long been one of the most reliable sources of demand for U.S. government debt.

Based on the Federal Reserve’s official custodial holdings, the most sustained pullback on record has happened lately as holders like China and Japan have culled their stakes in Treasuries for three consecutive quarters. Coinciding with the recent backup in U.S. bond yields, the decline has accelerated in the past three months.

That’s cause for concern for Jim Leaviss at M&G Investments in London. In a market that some say is already too expensive, a continued retreat could lead to painful losses. The consequences for America’s finances are perhaps more important. Foreign demand will be crucial in keeping a lid on borrowing costs, especially as the Fed continues to suggest higher interest rates are on the horizon with the U.S. facing deficits that are poised to swell the public debt burden by $10 trillion over the next decade.

Leaviss, whose firm oversees about $374 billion said that the selling pressure from central banks is “something you have to bear in mind. This, as well as the Fed, all means we are nearer to the end of the low-yield environment.”

Leaviss said M&G has scaled back on longer-term Treasuries and favors shorter-maturity securities to shield his clients from higher yields.

As the U.S. borrowed heavily in the aftermath of the financial crisis to revive the economy – overseas creditors have played a key role in financing America’s debt. Foreigners now own about $6.25 trillion in Treasuries as they have more than doubled their investments in Treasuries since 2008.

Central banks have led the way. As China’s export-based economy boomed, it funneled hundreds of billions of dollars back into the U.S. China is the biggest foreign holder of Treasuries.

But that’s all starting to change now. Following a decline of almost $100 billion over the first six months of the year, the amount of U.S. government debt held in custody at the Fed has decreased by $78 billion this quarter. Fed data shows that the drop is quadruple the amount of any full year on record and the biggest on a year-to-date basis since at least 2002.

Evidence that the retreat isn’t simply a one-off is given by the custodial data. China pared its stake to $1.22 trillion in July, the lowest level in more than three years, separate figures from the Treasury Department showed. There has been a reduction in their holdings by others like Japan and Saudi Arabia.

The reasons for selling are all tied to each country’s economic woes even as they vary. In order to defend the yuan as slumping growth leads to more capital outflows, the central bank has been selling U.S. government debt in China. As prolonged negative rates in the Asian nation of Japan pushed up dollar demand at local banks, the second-biggest foreign holder has swapped Treasuries for cash and T-bills.

And in order to plug their budget deficits following the collapse of crude prices, oil-producing countries like Saudi Arabia have been liquidating Treasuries. Marking the lowest since November 2014, Saudi Arabia’s holdings have declined for six straight months to $96.5 billion.

(Adapted from Bloomberg)

Categories: Economy & Finance