High levels of liquidity have prevented the spillover effect to the equity markets, but one needs to see strong corporate earnings to prevent money from leaving equities.
Global investors and central banks are pulling back on their investment in US Treasuries with President Donald Trump expected to follow an expansionary policy leading to a higher fiscal deficit and rising inflation. A higher interest rate outlook has taken the fizz out of the bond market — to the extent that it’s now being called a bond bear market.
A Bloomberg report says that few overseas investors want to enter the USD 13.9 trillion US treasury markets. Japan, China and European countries who are the main investors in US Treasuries are all sellers today.
Holding of foreigners in Treasuries has come down from 56 percent in 2008 to 43 percent today. Since the start of the financial meltdown foreign investors had been piling on US bonds and increased their holding from USD 2.2 trillion to USD 6.3 trillion. Their holding now stands at USD 5.94 trillion. For the United States this is a warning sign as it depends on foreign funds for its growth and bridging its deficit. Foreigners withdrawing at a time when the government wants to increase spending will add pressure on the US economy.
The impact of the selling could have been more severe but for buying by US nationals. Thanks to a slowdown for nearly a decade, the savings rate in the United States increased from 3.4 percent in 2008 to 5.8 percent presently. This has helped absorb most of the impact of the selling by foreigners.
However, it is not only interest rates that are resulting in withdrawals. Uncertainty in the US as far as policy is concerned is adding to the Treasury yield running ahead of government set rates. Kenta Inoue, chief strategist for overseas bond investment at Mitsubishi UFJ Morgan Stanley Securities in Tokyo has been quoted in the Bloomberg article saying: “It may be more difficult than usual for Japanese to invest in Treasuries and the dollar this year because of political uncertainty. Treasury yields may rise rapidly again in the near future, which will continue to discourage them from buying aggressively.”
The other and probably the main reason why foreign investors, especially central banks are selling the US Treasury is to 'manage' their currency. Take the case of China, which owns nearly USD 1.1 trillion of US bonds has been regularly selling since May 2016 taking its holding to a seven-year low. It is using the proceeds to defend its weakening currency and soften the impact of foreign exchange outflows from the country. US treasury officials have taken note of these moves by China and have threatened the country that it would be labeled as a currency manipulator. China has sold over USD 200 billion of US treasury over the last one year.
As the US dollar strengthens, other countries who export their goods to the US would allow their currencies to weaken to stay competitive.
Japan, the second-largest seller of US Treasuries, on the other hand, is doing so to buy its own bonds and so control its bond yields, which have repeatedly shown signs of spiking. This explains why the Japanese bond market has spiked despite the central bank policy of negative interest rates.
The volatility in the debt and currency markets globally has not yet transmitted to the equity markets. Rising interest rates have traditionally been bad for the equity markets as investors prefer to park their funds in deposits that assure capital protection at a time when interest rates can impact corporate profitability.
Similarly, a volatile currency market scares away foreign investors from equities as hedging costs increase, thus affecting their net yield.High levels of liquidity have prevented the spillover effect to the equity markets, but one needs to see strong corporate earnings to prevent money from leaving equities. If selling of US Treasuries continue, liquidity will be sucked out from the system. This will finally reflect on the equities market, and emerging markets are usually the first in line to take the hit. Indian stock investors should have this in the back of their minds.