Bond Selloff Not All Fundamentally Driven?

As we’ve discussed in recent market notes, the selloff in the bond market over the past few weeks has been driven in large part by concerns over fiscal reflation, the notion that inflation is set to rise because of President-elect Trump’s fiscal stimulus plans. While this certainly explains the directionality of the move, another factor may be contributing to the sudden and volatile spike in rates, namely sharply lower demand from foreign investors. The two largest foreign investors in Treasuries are China and Japan, both of which have largely avoided USTs in recent months despite the increase in yields. China has been dealing with capital outflows, which puts downward pressure on its currency. To combat this, China has been drawing down its foreign exchange reserves, much of which are invested in Treasuries, by selling dollars and buying renminbi. Through October, China’s UST holdings have declined for six straight months. Japan has also been on the sidelines. According to the Ministry of Finance, Japanese investors’ purchases of foreign bonds totaled $728 million in November, down 94% from October. Recent market volatility and elevated hedging costs are to blame. 

It’s easy to opine that if this trend in foreign sales continues Treasury rates will keep moving higher, but we think there is more complexity to the story. Over the last sixteen months, China has been net buyer of Treasuries in only two months, selling nearly a quarter of a trillion dollars of Treasuries during that span. Despite this selling, Treasury rates touched record lows over the same time period. So, while it’s easy to place the blame on foreigners for the recent market decline, ultimately economic growth and inflation will be the main factors driving rates.  

Source: BMO Capital Markets, WSJ