Yields on U.S. Treasuries have been declining throughout the 2019 calendar year, and that decline has recently accelerated. This has led to a discussion about where the demand is coming from and what groups are driving that demand. Many of these discussions have led to the conclusion that lower interest rates outside of the U.S. have driven foreign investors into the U.S. Treasury market.
While it is not possible to know the origin of every buy order, there are a few ways to monitor capital flows and foreign investor returns. This should help determine if it is reasonable to assume foreign investors are behind the increased buyer demand for U.S. Treasuries.
One place to look in order to monitor foreign buying of U.S. Treasuries is the Treasury International Capital (TIC) reports. These reports track capital flow into and out of U.S. securities by several types of foreign buyers. Looking at the TIC flows report, foreign investors have been net sellers of U.S. Treasury Bonds within the past twelve months.
There are more detailed versions of this report that track this metric by country, which will show the largest holders of U.S. Treasuries by domicile have been net sellers of long-term U.S. Treasuries.
Based on this data, we believe it is unsurprising that foreign ownership of U.S. Treasuries as a percentage of total outstanding has been declining. However, what is surprising is that their percentage of total ownership has been on a steady decline since 2008.
One of the main arguments why foreign buyers would be the driver of increased demand for U.S. Treasuries is the fact that interest rates in the U.S. are higher than other developed countries. While this is true, the widest gap between U.S. interest rates and foreign interest rates are short-term interest rates (using EURIBOR as an example).
The purpose of making the distinction of where the largest interest rate differential exists on the maturity spectrum is because the short-term interest rates are used to calculate the cost of hedging currency positions. In general, the higher the differential between short-term interest rates, the higher the hedging costs. Most large international investment groups (pensions, insurance companies, banks) are required to hedge some, if not all of their foreign currency exposure. When hedging costs are high, it eliminates the opportunity to make extra returns by buying longer-term U.S. Treasuries. This can be seen in the charts showing hedged and unhedged U.S. Treasury returns versus other countries.
Japanese bonds are the only recent example where hedged returns have been positive. Japan is a unique case as their central bank has focused on a target trading range for long term maturities and long-term interest rates there have not declined as much in the last few months as interest rates in the U.S. and Europe.
If foreign buyers are not going after U.S. Treasuries to take advantage of higher interest rates, then who is buying U.S. Treasuries? Based on the most recent data from the Federal Reserve Board as of December 31, 2018, Financial institutions are the largest holder. This includes several groups, such as banks and investment firms. In the last five years, the domestic buyers base has been growing the most (banks, mutual funds, individuals), while the largest foreign buyers (China and Japan) have been net sellers, and other foreign buyers have barely grown.
If U.S. based investors have been the source of increased demand for U.S. Treasuries, what has been the source of funds? Recently, the source of funds has been selling U.S. equities.
We believe that until short-term interest rates in the U.S. get more in-line with those of other developed countries, foreign buyers will likely not be large buyers of long-term U.S. Treasuries. This means that if concerns about the economic and corporate profit growth outlook remain in focus, capital to buy U.S. Treasuries will more likely come from domestic holders of U.S. risk assets, like equities and possibly high yield.
Rank Dawson, CFA
Vice President, Strategic Planning
Boyd Watterson Asset Management, LLC
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.