If Louise Linton ever manages to spend all of Steve Mnuchin’s millions on Louboutins and HermÃ¨s scarves and if he can’t recoup his fortune by selling a tell-all memoir about what it’s like to work for Donald Trump, he can always get a job as a finance chief in a banana republic.
Because God knows he’s done a pretty decent job of convincing people to buy debt issued by a country that’s inexplicably decided to pile deficit-funded stimulus atop an overheating economy run by a dictator who’s hell-bent on commandeering monetary policy.
Here’s what fiscal insanity looks like, in case you need a reminder:
Why in God’s name would you borrow to fund stimulus at a time when the unemployment rate just hit a 48-year low? I don’t know. Well, actually I do know – it’s because Trump needs to perpetuate the idea that he’s presiding over an economic miracle. In order to do that, he’s going to see if he can borrow his way to 15% GDP growth and 1% unemployment, and hope that by the time the chickens come home to roost on the debt binge, he’ll be hiding out in a chalet in Sochi under the protection of the KGB.
Anyway, what’s clear is that eventually, this lunatic plunge into unnecessary, debt-funded stimulus is going to dent demand for U.S. Treasurys. It hasn’t happened yet, but China reduced its holdings for a third consecutive month in August and if for whatever reason Trump ends up irritating the Saudis, well then they might just start selling some of their record stash on the way to short-circuiting the virtuous petrodollar recycling loop.
When you throw in hedging costs, you end up with more questions than answers when it comes to how the U.S. intends to fund its deficits going forward or if that’s not quite accurate, then you at least end up with questions about what price the U.S. will have to pay (i.e., higher rates).
It’s against this backdrop that JPMorgan takes a look at “the landscape for foreign demand” for U.S. debt, and while there’s not a whole lot that’s “new” (per se) in their analysis, it’s worth highlighting given the current environment.
“While foreign investors represent the largest cohort of ownership within the Treasury market, their share has declined from its peak of 50% earlier this decade to 43% as of YE 2017, the same share that persisted just prior to the Great Financial Crisis”, the bank writes, before asking what accounts for the slowing demand and posing the following questions:
Is it concern over the deteriorating US fiscal balance?
Is it burgeoning fears over trade and the risk that the dollar may lose its status as reserve currency?
Spoiler alert: It’s probably both. Drilling down, JPMorgan notes that global FX reserves plateaued in 2014 and the gradual decline is set to persist. Why? Well, two reasons.
First, JPM says that “the pace of private investor capital flows into EM has slowed sharply compared to the 2000s boom period and post-financial crisis era, and there is likely a reduced desire for intervention given the heightened sensitivity to charges of currency manipulation.” For their part, the bank sees FX reserve accumulation slowing to $200 billion next year from an average of ~$500 billion over the last two decades.
But beyond that, there’s the whole de-dollarization push which, while moving at a glacial pace, is nevertheless in motion, as you can see from the chart in the right pane below.
Obviously the de-dollarization debate is as contentious as it is long and winding, but one thing you should note is that the more aggressive the U.S. is when it comes to effectively using the greenback as a tool of economic warfare and deploying that weapon indiscriminately against allies and enemies alike, the more likely it is that the world will begin to see more utility in de-dollarization.
Ok, so that’s official demand. What about private demand? If you said private investors may be deterred by the prospect of losses from a possible end to the multi-decade bond bull market and also by hedging costs, you win a prize.
“With expected total returns likely to remain low as long as the Fed is expected to normalize rates, this should reduce foreign private demand for Treasuries, all else equal”, JPM writes, adding that “for private investors funded locally, Treasuries have become less attractive as yield pickup that a foreign investor can achieve by selling home-currency sovereign bonds and buying 10-year Treasuries, combined with a short-term FX hedge peaked in 2013-2014, but has been on the decline since then.” Here are the accompanying visuals:
So what’s the actual read-through for yields? It won’t surprise you that JPMorgan’s answer isn’t particularly alarmist, nor should it be. Clearly, it’s difficult for official investors to justify outsized allocations to something other than Treasurys, because even where the risk profile is the same, market depth is most assuredly not.
That said, the bank notes that a simple model (10-year Treasury yields as a function of real policy rates and foreign holdings as a share of US GDP), implies that “each $200bn decline in foreign holdings of Treasuries would raise 10-year yields by 7-8bp, ceteris paribus.” They go on to warn that if “a major foreign holder of Treasuries sold a significant share of its holdings over a short time period”, the “impact” of that selling could be non-linear.
That’s not their base case, though, and why would it be? After all, it’s not like there’s a major foreign holder who is extremely angry at the Trump administration right now…