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Foreigners Scramble To Buy US Debt Every Time Rates Rise

One of the persistent questions in 2017, has been how - with equities at all time highs - are Treasurys and other corporate bonds so strongly bid, and why is the 10Y still trading at a level that is more suggestive of a deflationary slump than an economic rebound.

The answer it turns out, is to be found offshore, and was especially visible the day before the Fed's unexpectedly dovish Wednesday statement, when yields and spreads blew out.

As Bank of America's credit strategist Hans Mikkelsen wrote in a Thursday note, when he observed the sharp move higher in yields and subsequent collapse at 2pm on Wednesday, "note the big rebound in net dealer-to-affiliate volumes following the recent notable increase in interest rates (Figure 3) - especially in the back end (Figure 4)." What the charts below show is the relative interest by offshore traders to buy (negative number) or sell (positive) US debt. What is most notable is that on the day yields and spreads spiked, so do foreign buying. In fact, in the total debt bucket, foreigners bought the most debt in the past year.

Some additional info on the charts above: Figure 3 shows the overall daily dealer-to-affiliate volumes while Figure 4 show a subset of this data. In particular Figure 4 shows net dealer-to-affiliate volumes for longer maturity (12+ years) bonds.

A note also also on Thursday by UBS confirms as much. According to UBS' Matthew Mish, "the critical marginal source of demand for US corporate debt has been non-US investors, primarily out of Japan, Asia as well as Europe. As we outlined previously they have accounted for nearly 40% of total investor flows into US corporate credit since 2014."

So what can put an end to its relentless demand by foreigners for US paper? Here's UBS:

For now, these flows are likely to weaken but not exit – likely pressured by less attractive relative value, rising hedging costs and rising supply of alternative fixed income investments. However, a scenario involving a material risk in credit risk and dollar weakness (vs. the yen specifically) are key risks to monitor, in our view. While today's ownership structure is not as fragile as the financial crisis (i.e. banks/dealers with significant financial leverage), our prior analysis suggests that the accumulation of debt this cycle has been concentrated in hands that sold more materially during the financial crisis (i.e., rest of world, funds, ETFs, Figure 10).


Meanwhile, as UBS adds, purely on fundamentals some demand signals "are flashing yellow," but are not red just yet.

US credit remains fundamentally expensive with HY and IG spreads roughly 1.1 and 1.3 standard deviations rich. But managers are long credit as growth is deemed reasonable enough to keep default rates below average and industry pressures from low interest rates, QE and passive vehicles is forcing many managers into the market. Some of our key signals are flashing yellow, but fall short of red flags. Our forecasts call for normalization in spreads towards fair value, with weak corporate earnings, policy uncertainty, waning foreign demand and lower oil prices as key downside risks; conversely, tax reform and oil prices into the $50s are upside risks. In the US our core positioning view favors intermediate US high grade bonds, particularly bank bonds as well as floating rate loans (relative to high yield), acknowledging expensive valuations.

Finally, looking at just the Treasury market using the most up to date proxy available, the Fed's Custody Account, the selloff observed in 2016 is now clearly over, and as of the week of July 26, foreign holdings of US paper parked at the Fed were back over $3 trillion, and just why of all time highs. So much for that great foreign dumping of US Treasurys.