US Treasuries: Safety in volume
US Treasuries, the ultimate safe financial instrument, are continuing to match investor demand even without the incentive of further rate hikes from the Federal Reserve
At a glance
• Although US economic growth is relatively poor it is doing better than most of its peers.
• There is a pool of domestic money that could enter the US Treasury market.
• The composition of foreign buyers of US Treasuries is changing.
• The US remains a safe haven for investors.
US Treasuries have always been the ultimate safe haven in times of economic turmoil but international investors are also seeing attractive relative value despite historically low yields. As the reality of the lack of further Federal Reserve rate hikes sinks in, domestic institutional investors seem likely to re-enter the Treasury markets. Bets are that yields will be lower at the end of 2016 than now.
“The US is the best house in a bad block, growing sluggishly but in the midst of what seems to be a sustained economic expansion,” says Vincent Reinhart, chief economist at Standish Mellon.
One of the reasons he says, is that the US, of all the advanced economies, was the first to recognise the wealth destruction that had occurred as a result of the 2008-09 global financial crisis, and attempt to implement policies to offset the impact. “We wrote a paper looking at the 15 worst financial crises in the twentieth century. What you find is that 10 years after the financial crisis, the GDP per capita is 15% below what the trend before the crisis would have led you to predict. 10 years is a long time and 15% is a big amount.”
Reinhart argues that a crisis represents an enormous hit to a nation’s wealth. After a crisis, governments need to admit to a wealth loss, they need to allocate the costs to their citizens and use other policies to offset the effects of that loss as best they can. “If you look at the US, it had a deep recession and then an initially shallow recovery. But, whatever you think about the stress tests, at least it was the beginning of the recognition that we had lost wealth and an attempt to allocate it across the citizens and importantly, the taxpayers. And then we could use macro policy to help offset some of the impact of that.”
Over the last few years, most large plan sponsors in the US have avoided the bond market because they have been waiting for the Fed to raise rates. They were monitoring the Fed’s Summary of Economic Projections (the Fed’s Dot Plot) which projected a Fed Funds rate of 3.5%–3.75% several years out (this was largely aspirational).
Bob Michele, head of global fixed income at JP Morgan Asset Management, says: “They wanted to see as the Fed raised rates, what would happen to the bond markets. If you are an underfunded pension fund, a rise in long-term rates would deflate your liabilities. People were caught out as they realised the Fed was not going to raise rates to 3% or even 2% in this cycle and it will be hard to even get to 1%. So there is this pool of money that will enter the Treasury and bond markets as the realisation that possible Fed tightenings are not going to give rise to the knock-on effects that they had been waiting for.”
It is also clear that while the composition of foreign buyers of Treasuries has changed since the crisis, there is still to be sustained demand. Karsten Bierre, head of macro and strategy at Nordea Investment Management, says foreign investors take comfort from the US’s position as the world’s largest economy and one of the most stable. “People talk about rising government debt. But, when it comes to the US, they ignore the fact that in the US, there is a very large private surplus on the other side. So if you look at the current account deficit for the US economy, it has been fairly stable for the past few years, hovering around 2.5% of GDP.”
He adds that US foreign debt has grown slowly and is currently less than 40% of GDP, while net income for the US is actually positive. In contrast, the government debt-to-GDP ratio exceeds 100%. That arises because when US institutions invest abroad they tend to get higher returns than foreigners get when they invest into the US, because US investors tend to prefer high risk equities and direct investments. In contrast, overseas investors in the US opt for the fixed income market.
The composition of foreign purchasers of Treasuries has changed. China was one of the largest institutional purchasers of Treasuries. But, as Michele argues, China has moved from accumulation to decumulation as part of its foreign exchange activities. “The expectations of a possible hard landing in the Chinese economy led to capital flight and they had to sell Treasuries and buy renmimbi. The data shows that has stabilised and the government has stepped in and is spending more on infrastructure to support GDP growth at 6.5% and 7% which has created capital inflows again.”
According to Bierre, flow data shows a shift in foreign purchases of Treasuries from official buying to private purchases alongside an increase from domestic pension funds and investors. “There has been a shift from forced purchasers of Treasuries for foreign exchange management to purchasers like ourselves who see relative value.”
Nordea is buying Treasuries along with UK Gilts as they are offering a pickup compared with other safe bond markets such as Germany, Canada and Japan. “Tactically, we are seeing some inflation pick-up in the US, so we are underweight duration but have a strategic allocation,” says Bierre. “The lion’s share of our government bond portfolio is allocated to the Treasury market across the entire yield curve, although mainly around 5-10 years. The long end tends to be driven by liability-driven investments so it is harder to determine fundamental valuations there.”
Alongside European institutional investment, the other flow is Japanese private as opposed to public investment. As Michele explains, the Japanese flows started two or three years ago following the introduction of quantitative easing (QE): “That allowed investors to take their capital, invest in a foreign bond markets and then hedge back into yen. With the Fed cutting rates to close to zero, it meant that any Japanese institution buying US bonds could hedge back into yen at no cost.”
Recent Japanese policy has led to a flood of private investment in Treasuries. “The Bank of Japan was the first to undertake a zero interest rate policy, the first to undertake QE, but one of the last to cut rates into negative territory.”
Anxiety levels in Japan have increased with central bank rates turning negative. “All safes in Japan were sold out the weekend they cut rates into negative territory. As they went through that psychological barrier to get to negative 10 basis points, the Japanese understand they are going to see more cuts so we have seen a ramping up of the export of capital to the US. Whether retail or institutional, the flows of investment out of Japan have been extraordinary. Yields on Treasuries look generous relative to what investors could receive in either Japan or Europe.”
Foreign institutional purchases of Treasuries though, are not driven just by relative value. There is still the perception, as Bierre argues, that in times of trouble, Treasuries will provide the safety it has always done. “That is supported by the central bank. During the crisis, the Fed was at the forefront and their willingness and ability to act during the financial crisis was impressive and the US has generally fared better after the financial crisis than Europe and Japan.”
Reinhart says there is little doubt that US Treasuries will remain a safe haven for the foreseeable future. “There is a deep principle of economics that you can’t beat something with nothing. The Treasury market is still the most liquid biggest market. The single largest asset class out there. Since there is no plausible alternative, the Treasury market will remain the favoured market for some time to come. The consequence of official interest in Treasuries is impairing liquidity but it is still more liquid than anything else. The Fed and foreign entities hold the majority of Treasuries, but it is still a liquid market across lots of maturities and lots of different instruments.”