Conclusion: China continues to diversify its FX holdings away from U.S. Treasuries while the rest of the world (including the Fed) continues to buy. Just as it has been for global growth over the past 18-20 months, we believe China’s selling is an important lead indicator regarding the future of U.S. Treasuries and the U.S. dollar.
Position: Short 1-3 year U.S. Treasuries via the etf SHY. Short the U.S. dollar via the etf UUP. Long the Chinese yuan via the etf CYB.
The most recent TIC data was released today and it confirms one of Hedgeye’s key long-term TAIL ideas that the U.S. Dollar will continue to make a series of lower-highs and lower-lows from a long term perspective. China, the largest holder of U.S. Treasuries, continued to be a net seller, lowering its U.S. Treasury holdings by an additional $24 billion in June to $843.7 billion. Since July 2009’s peak holdings of $939.9 billion, China has sold a cumulative $96 billion of U.S. Treasuries with a quarter of that total coming in the most recent month for which we have data (June ’10). Moreover, China has nearly liquidated its holdings of short term bills, which peaked at $210.4 billion in May ’09 and are now at $4 billion – a 98% decline!
In contrast to China’s selling, total net foreign purchases of U.S. Treasuries increased to $45.7 billion in June vs. +$24.3 billion in May. Japan (#2 holder) and the U.K. (#3 holder) each increased their exposure to U.S. Treasuries in June, up $16.9 billion and $12.2 billion, respectively.
We continue to have conviction that the largest bubble remaining in the global marketplace is that of short-term U.S. Treasuries. At ~50bps, the yield on 2-year Treasuries is at its lowest level ever. Ever, as they say, is a long time and that represents one of the most asymmetric risk setups globally marketplace – yields can’t go down much further from here, we believe. In fact, because of the premium investors are placing in “safe” assets in light of global growth slowing, we feel the market has not priced in what we feel are substantial long term risks to U.S. Treasuries and the U.S. Dollar. We highlighted those risks two weeks ago in a note titled: China’s Stress Tests(s): Risks to the Global Economy. Excerpts below:
“In a recent study done by the Congressional Budget Office, U.S. federal debt held by the public as a % of GDP is likely to eclipse 185% in just 25 years under scenarios that we consider aggressive based on assumptions of above-trend tax receipts and below-trend expenditures – which certainly hasn’t been the case of late (see Daryl Jones’ note from 7/13: The Deficit Still Looks Ugly, Normalize for TARP and It Looks Uglier). The results of the mid-term elections may prove to be a positive catalyst on the margin for reigning in the deficit, but a slowing U.S. economy may ultimately prove to trump any form of American Austerity.
On August 3rd, we put out an extensive presentation regarding the future of U.S. sovereign debt (email us if you need the replay), with the key takeaways being: 1) current demographic trends will likely beget further deficit spending; 2) a low U.S. savings rate will necessitate that an increasing amount of foreign buyers will be required to fund new debt issuance; and 3) at current and conservatively-projected near-term debt levels (+90% of GDP), U.S. economic growth will be below-trend for years to come – likely furthering the “need” for additional government spending and investment. All told, the U.S. is likely to issue a great deal more of U.S. Treasury supply in the coming decades and buyers of that supply will be increasingly foreign entities, which increasingly makes the U.S. vulnerable to external shifts in demand for U.S. sovereign debt – which is currently near all-time highs. If we’ve learned anything from Greece’s sovereign debt woes, it is that, ultimately, the market can and will re-price sovereign debt and reset the cost of government borrowing.
It is important to note that we aren’t suggesting that U.S. Treasuries are following in the footsteps of Greek sovereign bonds. What is likely to happen based on historical precedent set by Japan is that Treasury yields stay low as a result of prolonged near-zero interest rates. From a central bank action perspective, there hasn’t been a threat to Japanese Government Bonds in decades and the United States has already started on that path. What matters to China, however, is converting those debentures into cash upon maturity. The U.S. Dollar Index continues to make as series of lower-highs and lower-lows from a intermediate and long term perspective, meaning that as time elapses, China is likely to receive less and less purchasing power from converting U.S. Treasury debt into actual currency. The U.S. dollar is still the dominant currency as a percentage of world currency reserves, but, as we say, everything that matters in Macro happens on the margin. In the last ten years alone, the dollar has declined over one thousand basis points as a percentage of world FX reserves, falling from 71.9% in 1999 to 61.5% in 2009, according to the IMF. The outlook for the U.S.’s economic growth and debt build-up over the next 20-30 years suggests the dollar will not likely regain any of its lost value any time soon.”
All told, China considers the risks to holding U.S. treasuries so great, that it favors Japanese Government Bonds over them of late. China bought more Japanese bonds than it sold for a sixth month in June (456.4 billion yen vs. 735.2 billion yen in May), heading for the biggest annual increase since at least 2005, according to a recent report by the Ministry of Finance in Tokyo. Even with a government debt-to-GDP ratio north of 200%, JGB’s still represent a more attractive investment for China’s FX reserves than U.S. Treasuries, which says a lot about what could be coming down the proverbial pike for the U.S. Dollar.
As Keith penned in today’s Early Look, capital chases yield either through growth or high interest rates and the intermediate-to-long-term outlook for the U.S. has neither. Perhaps that’s why foreign investors sold $13.5 billion in U.S. corporate bonds in June (the highest amount since January 2010), and another $4.1 billion in U.S. corporate stocks (the most since July 2008). All the while, Capital continues to pour into places like China, SE Asia, and Brazil. Just recently, ICBC Credit Suisse Asset Management Co. raised 14 billion yuan ($2.1 billion) to set up China’s largest bond fund. Expect this trend to play out over the long term as the world continues to diversify away from dollars within their FX reserves and as global investors chase yield away from a slow-growth U.S. economy.