China right to resume US Treasury purchases
As bond yields rise, bond prices fall. With the Federal Reserve set to raise interest rates again this week, and more increases possible, US Treasury prices might be expected to decline to reflect the Fed’s actions. So, it might seem odd that China has again been boosting its holdings of US Treasuries. Why start buying if prices should fall?
But Beijing may be ahead of the game.
As the South China Morning Post reported last week, China is prepared to continue to increase its holdings of US Treasuries if, admittedly unspecified, circumstances are right and it was acknowledged that the trend, which has seen Beijing buy US paper for two months through March after reductions in all but one of the previous seven months, is being maintained.
Perhaps we are seeing the manifestation of a theory given expression by London-based Eurizon SLJ Macro last week that “there are at least two different concepts of globalisation: trade and financial globalisation” and that while the former, in which China had been front and centre, “has been multipolar in nature … financial globalisation may have been much more unipolar”.
And defining unipolar, Eurizon SLJ Macro argues “the role of the US dollar and US assets may have become even more dominant” and therefore “the divergence in trade and financial globalisation has in turn resulted in a situation whereby the genuine safe-haven assets such as US Treasuries, German bunds and British gilts become increasingly rare and in short supply”.
If demand for US Treasuries is disproportionately strong compared to supply, the capacity for Fed policy tightening to put upward pressure on US bond yields is greatly reduced.
However, as a recent Project Syndicate piece, by Bradford J Delong, Professor of Economics at the University of California at Berkeley pointed out, when it started raising rates in December 2015 the Fed’s median forecast was that its “preferred inflation measure – the core personal consumption expenditures (PCE) price index – would be at 1.9 per cent per year by now.” It isn’t.
And that forecast envisaged nine rate rises in the intervening period.
As it is, DeLong noted that “if the Fed actually does increase interest rates this month, it will have undertaken only four of the nine anticipated rate rises” while now “inflation is expected to rise at an annual rate of just 1.5 per cent for the rest of this year and next year”.
As Minneapolis Fed chief Neel Kashkari wrote in March, following his vote against the US central bank raising rates then, “over the past five years, 100 per cent of the medium-term inflation forecasts [midpoints] in the [Fed’s] summary of economic projections have been too high”.
At the same time, with US income growth pretty lacklustre and US household borrowings having risen to US$12.7 trillion, how far can the Fed anyway tighten monetary policy without adversely affecting domestic consumption, which is the key driver of the US economy?
All in all, if bond market practitioners consider that the Fed may decide to push back or limit the frequency of future rate rises, then bond yields could well not rise in tandem with monetary policy tightening and so bond prices would not slide.
Indeed, as Eurizon SLJ Macro observed last week, “since December 2015, the Fed has raised rates three times – and project to continue to do so, reaching a terminal rate of close to 3 per cent – but the US 10-year bond yield is at roughly the exact same level as it was in December 2015”.
Additionally, just last week, bond markets will also have noted how the relative absence of inflationary pressure in the US is mirrored in Europe.
The European Central Bank, despite an improvement in economic data in the euro zone, on Thursday last week lowered its own forecasts for core inflation in the next two years.
Once energy and food prices are excluded, the ECB now expects inflation at 1.4 per cent in 2018 and 1.7 per cent in 2019, compared with previous forecasts of 1.5 per cent and 1.8 per cent respectively.
In China, with its huge global exporting footprint, producer price inflation eased in May for the third consecutive month. A sustained moderation in inflationary pressure at China’s factory gates might well, through the export channel, send a disinflationary ripple across the world.
A US rate rise this week is a near-certainty but US bond prices may continue to defy gravity. Whether the Fed follows through, as it currently expects, with two more increases in 2017 is now debatable. Circumstances may indeed favour a continued resumption of US Treasury purchases by China.