It is the 22nd of October 2019

China Treasury Holdings Rise For 6th Month, But The Streak May Soon Be Ending

According to the latest Treasury International Capital report issued today, four of the top five US foreign creditors added to their holdings of US Treasurys in the month of July (not adjusted for market price fluctuations), with the two largest, China and Japan, adding $19.5BN and $22BN to $1,113.1BN and $1.166BN, respectively (the Cayman Islands, i.e. hedge funds, saw a modest reduction from $265.2 to $259.2 billion). This was the 6th consecutive month of gains for China since its holdings dipped to multi-year lows in late 2016, bringing its Treasury holdings to the highest since August 2016. More surprising here is the steady bleed in Japanese TSY holdings, which despite the modest pick up in July have been on a steady downward trends since 2014.

The recent purchases by both official (central banks, reserve managers, sov wealth funds) and private entities, has resulted in a sharp reversal in LTM Treasury purchases. After hitting a record $397 billion in outflows last November, foreign official holdings of TSYs have been on a steady LTM cumulative rebound and as of July, foreigners had sold a total of $235.6 billion, the lowest  12 month cumulative total since December 2015.

That said, the ongoing buying spree may be in danger for two reasons: first, should the Fed's balance sheet reduction announcement on Wednesday not have been fully "priced in", it may spook markets, sending yields higher, and spooking potential buyers, pushing TSY prices even lower.

The second reason comes from Bank of America, which looks at the recent announcement by the PBOC to let the Yuan dip by aiding speculators, and concludes that this could have a negative impact on China's accumulation of US paper. Here is BofA's Shyam Razan:

One of the biggest surprises relative to our expectations this year has been reserve manager buying of USTs - the weakness in the USD and strong inflows into EM has helped reserve managers rebuild their dollar portfolios (buy dollars, sell local currency). The reserve growth has been broad-based (e.g. China +80bn, India +38bn, Korea +23bn) and a substantial amount has been diverted into USTS as evidenced by the ~$180bn growth in custody holdings ytd (Table 1). China's interventions to prevent a substantial appreciation in the CNY below 6.50 have arguably played a part. Now, to the extent that the easing of capital controls (removing the reserve requirement as suggested last Friday) is successful, it would necessitate lesser interventions (dollar buying) on the part of the PBOC, resulting in lesser inflows into USTs. This is why we believe the back-up in UST yields that started last Friday coincided with the announcement by the PBOC (chart 2).

If BofA is right, and if China (and others) step back again, the Fed may find itself reducing its balance sheet and hiking rates just as some of the biggest foreign buyers suddenly find they have less appetite for US paper, potentially prompting a sharp vol spike in Treasurys, which as a reminder was listed earlier today as a potential catalyst for a marketwide risk-off event.

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