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Bond Yields Tumble To 2017 Lows After China Said "Ready To Buy More US Treasuries"

Confirming what we reported two weeks ago, when we said that based on Treasury custody holdings at the NY Fed "foreign central banks have been quietly scooping up US treasurys", moments ago Bloomberg reported that China is prepared to increase its holdings of U.S. Treasuries "as officials judge the assets are becoming more attractive than other sovereign debt and as the yuan stabilizes."

Citing source, Bloomberg adds that Chinese policy makers expect that U.S. government debt will be more attractive compared with other countries’ assets, and again confirming what we showed on May 25, adds that China has recently stopped reducing its holdings of U.S. bonds.

While the move is a reverasal to China's liquidation of US paper in 2016, when reduced its ownership of Treasuries by the most on record as it sought to defend a weakening yuan, it merely confirms recent trends observed in both the Treasury's TIC statement and custody holdings data. Bloomberg confirms as much, reporting that "China has since changed strategy, adding to its holdings in the two months through March."

Following the Bloomberg report, the 10Y Treasury yield dropped to a new YTD low of 2.136%, while the 5Y has slid to 2017 lows of 1.6909%.

For those who missed it, here are excerpts from our May 25 report titled "Foreign Central Banks Are Quietly Scooping Up US Treasurys", which previewed all that Bloomberg just reported.

As the latest custody data from the Fed reveals, in 2017, debt held at the Fed on behalf of foreign central banks has jumped by $61.2 billion to $2.922 trillion, the highest level since June 2016.

One of the biggest buyers has, perhaps surprisingly, been China - the second largest foreign holder of US paper after Japan - which after selling $188 billion in Treasurys in 2016 has bought $29 billion YTD according to the latest TIC data. A main driver behind this mini buying spree is that the relentless Chinese reserve outflow, which started in late 2014 and continued for over 2 years, has moderated after the PBOC erected an unprecedented firewall to contain capital inside the country, and which has removed the pressure on the PBOC to liquidate US-denominated assets to offset the capital outflows.

As the WSJ observes, China’s foreign reserves slid more than $500 billion between August 2015—when China shocked the world with a one-time devaluation of the yuan—and December 2016. The reserves have since rebounded from $3.01 trillion in December to $3.03 trillion in April. The slowdown in reserve outflows has also afforded the Chinese Yuan with a period of surprising stability, which has been cited by some as the reason why emerging markets have remained very stable in light of the recent geopolitical and commodity volatility.

Another factor was the strength of the dollar. as the recent reversal in the greenback has helped fuel central-bank buying of Treasurys. The strengthening USD from mid-2014 until the end of 2016 created a "negative feedback loop in emerging markets, with capital leaving developing economies, which then caused local currencies to tumble."

The weaker dollar in 2017 has also helped stabilize local EM currencies and reduced the need for central banks to sell Treasurys and use the open-market proceeds to intervene in the currency market.

Through Wednesday, the dollar had fallen 1.4% this year against the Chinese yuan freely traded in the offshore markets, after a 6% rally in 2016. And while the Yuan was barely changed the day of the Moody's downgrade, on Thursday Yuan, both the onshore and offshore, surged by the most in 2 months after at least two Chinese banks sold dollars in the onshore market, in what traders dubbed was a direct manipulation of the currency by Beijing, as the PBOC’s daily fixings had "materially diverged" from the prescribed formula resulting in a gap between the reference rate and currency’s spot value. And according to Khoon Goh of Australia & New Zealand Banking Group, instead of sticking to fixing formula, the central bank opted for active intervention to narrow the difference.

But back to Treasury flows, where in addition to China other foreign central banks have been bidding up US paper as it continues to offer more attractive yields compared with peers in Germany, Japan and the U.K. During the first quarter, Saudi Arabia’s Treasury holdings rose $11.6 billion. Russia’s holdings rose $13.7 billion, South Korea’s was up $4.2 billion and Singapore’s was up $2.5 billion. Even Japan, which earlier this year dumped the most US Treasurys since May of 2013 is back in the fray, only this time it is no longer hedging its dollar exposure, a decision which may prove painful once currency volatility returns.

A further reason for the return of foreign buyers is that after dropping at the start of the year, the price of 10Y TSYs has rebounded sharply, making the purchase a safer proposition. Purchases from foreign central banks had contributed to declines in Treasury yields this year after a big rise in late 2016. That in turn has caused hedge funds and money managers to exit from or pare back bets that bond yields would extend a climb.

This  process is now in reverse, just as the Fed is warning of not only a June rate hike but potentially unwinding its balance sheet as soon as September.

“There are not a lot of options for foreign central banks’’ to diversify their portfolios away from the Treasury bond market, said Bill Northey, chief investment officer at the private client group of U.S. Bank.