LONDON (Reuters) - Few have flexed their muscles in the U.S. bond market over the last 15 years quite like foreign central banks, who have played a major part in the bull run by recycling their trade surpluses and building up trillions of dollars of currency reserves.
But that was when bonds were rising. They may be powerless to fully protect their vast holdings of U.S. Treasuries when the market turns and prices start falling, a long process that many observers say we are in the early stages of right now.
A fall in the price of U.S. bonds will wipe tens or even hundreds of billions off the value of central banks’ holdings, but trying to get out and sell early is dangerous because that would almost certainly accelerate the decline.
These institutions aren’t short-term traders, they’re long-term investors who don’t react in a knee-jerk fashion to market moves. When it comes to their FX reserves, stability and capital preservation are paramount.
Yet the list of reasons why they might want to loosen their ties to the U.S. dollar, bonds and financial ecosystem in general is growing. Especially if the current Treasuries sell-off proves to be the start of a proper reversal.
The focus is on China, which holds $1.2 trillion of U.S. Treasuries. But there are smaller holders - “free riders”, as economist Nouriel Roubini once dubbed them - who collectively pack a powerful punch.
Algeria and Turkey, for example, each hold around $100 bln of FX reserves, and Iran has over $130 bln. Many smaller holders will have their Treasuries in custody centres such as London or Luxembourg.
China selling, or just not buying more U.S. bonds, would be a significant development, pushing up U.S. borrowing costs and potentially denting U.S. growth. Similar behaviour from Roubini’s free riders could have a similar impact too.
You can see why they might consider it. Many could join China and get sucked into trade disputes with Washington, some may want to reduce their dependency on the dollar, and others might want to distance themselves from an increasingly hostile and unpredictable U.S. administration.
But they will be mindful of the damage that could do to their stash of Treasuries, borrowing costs, and GDP growth.
“They are limited in that any damage they do to the U.S. will rebound both on themselves and on other countries. So a bit of an own goal,” said Steven Englander at Standard Chartered.
The stakes are huge. Global foreign exchange reserves total $11.59 trillion. Most of that is held by emerging markets, including oil producers.
The U.S. Treasury market is a $15.7 trillion market and foreign central banks hold $4 trillion of Treasury securities, $3.67 trillion of them bonds. The true figure is probably even higher once sovereign wealth funds are factored in.
The degree to which central banks muscled their way into the U.S. bond market over the last 15 years is astonishing, especially in 2003-08 when current account surpluses, oil revenue and reserve accumulation soared.
Global reserves more than doubled in that period to $7.3 trillion from $3 trillion. China emerged as a world economic superpower growing up to 10 percent a year, and its FX reserves grew fivefold to $2 trillion from $400 billion.
Current account surpluses in the emerging world ballooned. Saudi Arabia’s nudged 30 pct of GDP in 2005 as rose to a record $147 a barrel in 2008 from $30 in 2003.
These dollars flowed back into U.S. assets to plug the yawning current account deficit, which topped out at a record 6 pct of GDP in 2006.
The U.S. bond market boomed and continued to boom after the crisis thanks to the Fed’s $3.6 trillion QE programme. But it’s a different picture today.
The Fed is shrinking its balance sheet, and from October 1 it will allow maturities of $50 bln a month to go unreinvested. That’s $600 bln a year, a big demand gap.
Supply is rising fast as tax cuts and higher defense spending blows open the deficit. Gross Treasury issuance topped $1 trillion on a monthly basis for the first time ever in August, according to SIFMA data.
Meanwhile, Washington is imposing tariffs on imports and slapping financial sanctions on Russia and threatening others. And no bank wants to risk becoming another BNP Paribas, which was fined $9 billion by the Justice Department in 2015 for violating U.S.-imposed sanctions against Sudan, Cuba and Iran.
The U.S. bond market’s demand and supply dynamics may be shifting. The 10-year yield rose to 3.09 pct this week, near its highest since 2011. If the selling accelerates many countries may want to get out, but find their hands are tied.
The opinions expressed here are those of the author, a columnist for Reuters.
Reporting by Jamie McGeever; Editing by xxxxxxxxxxxx