I have run across data that belongs in the category of strange and unusual in the May 15th publication of the TIC data (Treasury International Capital Report).
The strange aspect of the data is that in the published figures, the tiny country of Belgium with a GDP of only $509B, somehow managed to purchase $40.2B in Treasury securities in the month of March. The purchases follow a six-month barrage of purchases by Belgium in which $214.6B in Treasuries were added to security accounts held in the country. Based on the data, Belgium has escalated to third, behind only Japan and China (mainland) in the rankings of foreign countries which hold the most U.S. Treasury reserves.
For multiple reasons, the buying taking place is very unlikely if not impossible to be coming from the Belgium government. The purchases over a six-month span represent 42.4% of the country's GDP, which is only growing at 1.2% annually. The TIC data footnotes do point out:
"Since U.S. securities held in overseas custody accounts may not be attributed to the actual owners, the data may not provide a precise accounting of individual country ownership of Treasury securities."
In the case of Belgium, a precise accounting I guess not. Given the massive central bank interventions by the Federal Reserve, BOJ and the EU, the information of who the actual owner is in this case might be useful investor information. It could shed light on why Treasury bond yields in the U.S have been plummeting back toward all-time lows since the first of the year when so many expected the opposite. As the banner at the bottom of the graph points out, over the past year total foreign ownership of Treasuries went up only $224.4B. Netting the puts and takes from all the other countries in the world, Belgium was the primary buyer. Does anyone else find this data strange?
Why is the Foreign Treasury Investment Flow Important?
When you turn on any business news channel in the U.S., one of the metrics followed religiously is the yield on the 10-year Treasury. The 10-year is looked upon as the Holy Grail as the barometer of U.S. GDP growth. I believe this was a decent indicator in the distant history, probably pre-1994. However, since that time the Treasury complex has become an amalgamation of foreign entrenched special interests (47.1% ownership) protecting their stake in the U.S. economy. Much of the ownership can be traced back to multinational companies with large balances of unrepatriated profits held overseas, as well as state-run economies holding reserves to advantage their Treasury positions with the United States.
In addition, as the graph below reflects, there is also a rising degree of Federal Reserve Bank direct ownership (18.4% ownership). The ownership numbers are calculated based on the U.S. Debt which is actually available for sale in the public market. As of March 2014, publicly-traded debt was $12.6T of the total $17.6T in National Debt. The delta is intra-government accounts made up primarily of Trust funds like Social Security which is mandated by law to take an IOU from Uncle Sam and is not part of the public float.
If you examine the numbers in the context of the Belgium conundrum, and the perplexing drop in the long-term Treasury rates since the beginning of the 2014, an interesting set of information surfaces.
- Rate declines on Treasuries have most likely not been driven by purchases from U.S. private citizens or U.S. domiciled businesses. U.S. ownership of Treasuries has been virtually unchanged year over year, and in fact declined as a percentage of the total from 36.7% to 34.5%. This trend to lower and lower U.S. ownership dates back to the mid 1990s. Anyone researching the cause of the slow growth, deflationary issues being experienced in the U.S. economy today might want to study what changed at this point in history.
- Foreign ownership over the past year increased over the past year from $5.74T to $5.94T, which in retrospect is a small increase and actually led to a total ownership of the traded pool of Treasuries to 47.1% from a historical high water mark of 48.2%. The Belgium purchases are already noted as the primary anomaly that kept this number from being flat year over year, just like U.S. private ownership.
- This set of data means that on the margin, only the Federal Reserve Bank plus the mysterious Belgium buyer(s) are the investors driving interest rates lower and lower on U.S. Treasuries in 2014. Based on the data from the past year, the Federal Reserve increased its Treasury ownership to $2.32T in March (now $2.35T at the end of April), which is $485B more than it held as of March 2013.
Another market trend that is presently favorable to Treasury interest rates is that the U.S. federal government need for funds is both seasonally low as well as declining as a percentage of GDP owed to fiscal constraints and tax increases imposed by Washington over the past year. However, there is still a historically large deficit that will need to be financed once the Fed steps aside from its bond purchasing program.
Where will the funds flow from is the question investors need to answer, and at what price?
One Country Not Expected to Ante Up - Russia
One of the negative drains on foreign investment flows to finance the U.S. account deficit is the growing conflict between the U.S. and Russia. A look at the TIC data for the past year shows Russia's Treasury ownership on the decline.
The data shows reductions of almost $50B in reserves held by Russia since October 2013, with a steepening of the run-off happening after the start of the siege of Crimea. Whether these reserves were simply moved to avoid the threat of U.S. freezing of custodial accounts held within reach of U.S. authorities is unclear. However, one should expect that Russia is likely to seek an increasing level of non-dollar denominated trade transactions with its trading partners. The recently reported Russian effort to increase direct trade with China reinforces this probable path.
Emerging Markets also Show Declining USD Reserves
Although the TIC data does not show an unstable sell-off in Treasury reserves around the world, the emerging market data is a growing issue. As might be expected based on the media coverage of economic slowdowns in emerging markets in 2013, countries like Thailand, Turkey, Peru and Chile all exhibited large % declines in U.S. Treasury reserves over the past year.
In reviewing the data in detail, net of the Russia $50B decline, there was $125B in USD based reserves sold across primarily emerging market and oil exporting countries over the past year. The biggest total dollar declines were recorded in Thailand ($20.3B), Oil Exporting Countries ($17.7B), Taiwan ($12.5B), and Brazil ($12.6B).
This trend most likely reflects lower U.S. trade demand prompted by a combination of constrained fiscal policy and increasing domestic energy production.
Japan Fills the Gap, China Holds Steady
Who filled the $100B gap left by the emerging market and oil exporting countries over the past year? Japan.
No analysis of the TIC data is complete without taking a look at the trend in the level of Treasury reserves held by China and Japan. The two combined own 41.6% of the foreign held U.S. Treasuries. Over the past twelve months, Japan, most likely owing to the "Abenomics" quantitative easing program and the return of the carry trade in early 2013, increased U.S. Treasury holdings by $86B. The impact has been the typical weakening of the Japanese yen against the USD. However, this time around the Japanese current account has remained in a deficit rather than moving to a surplus due to the need for energy imports which continue post the nuclear power disaster at Fukushima.
China, on the other hand, has not expanded its reported Treasury ownership in the past year.
Overall the sustainability of the Japan source of funds for U.S. financing needs as the BOJ program winds down is questionable. Likewise, unless China is a mysterious indirect buyer in Belgium, as one of the emerging market trading partners whose GDP is being affected by US domestic policies, they too are not a likely large source of funds going into the latter half of 2014 as the Fed tapers.
Summing Up the Growing Risk
So, where will the funding come from to finance continued account deficits as the Fed tapers going into year-end 2014 and then beyond?
The current market for U.S. Treasury securities is heavily skewed by a number of factors which do not appear to be sustainable over the intermediate term, however seem certain to continue over the very near term. The first is the declining need for Treasury borrowing.
"U.S. finances have improved steadily over the last year as higher tax rates and an improving economy lift government receipts while spending holds roughly steady.
The Treasury earlier this week said it would pay down $78 billion in government debt during the April to June period, the biggest quarterly reduction in seven years."
In an environment of more limited U.S. borrowing needs and historically low interest rates being offered on the Treasuries being sold, the Belgium plus Federal Reserve contingent of buyers in the market have been able with relative ease to keep a cap on the Treasury yield curve. In fact, anyone shorting Treasuries into this scenario while the Fed is still purchasing $35B a month in Treasuries should not be surprised that the market is not moving in their favor at the present moment. However, given that the rates are being set with very little direct investment demand from a broad cross section of the financial market, it begs the question: "what information is truly being signaled by the drop in the long-end of the curve by almost 50 basis points on the 10 year and 60 basis points on the 30 year since year-end 2013?"
My opinion is that it is reflecting little more than that the Treasury has cornered the market for long dated Treasury paper. Based on a review of the maturity structure of the debt, it appears the Fed has over 48% of all 10-year maturity and beyond Treasuries in its holdings.
Will the situation unravel as the year unfolds? The answer to this question is simply a function of where the money flows from to finance the U.S. deficit as the Fed withdrawals.
Many investors may believe that if the situation does get unstable, the Fed will just re-enter with bond purchases and magically restore order. But sooner or later this solution moves from the sublime to the ridiculous as an antidote for the U.S. economy. A monetary illusion can only last for so long, and this one requires a continued orchestration of BOJ and EU central banks and also directly impacts the growth prospects for emerging market economies which is sure to begin to intensify the ill will of potential Russian allies. In other words, one of the foreign policy choices by the White House is becoming, continue QE, and the risk of worldwide conflict continues to escalate.
Are there signs that the monetary illusion will break down soon? In my last article, "Market Winds are Shifting, Time to Assess the Signals", I noted several key indicators which typically coalesce if the U.S equity market is headed for a major bubble bursting correction. Several indicators are cautionary, and primarily involve the interaction of U.S. budget constrains against a backdrop of tapering QE. Also noted in the article, the two most expensive markets at the present time in relative terms are U.S. Treasuries (NYSEARCA:TLT) and the major market indexes (NYSEARCA:SPY) (NYSEARCA:DIA).
One potential scenario which seems very likely is that once the technical factors which are limiting the Treasury needs for financing currently begin to abate, and the Fed moves aside, the stock market is going to become the primary competing source for government financing needs. David Tepper seems to be one major hedge fund manager that senses the impending potential danger ahead.
"Don't be too fricking long right now," he said, referring to bullish positions. "There's times to make money and there's times not to lose money." (see Forbes)
Although I can't speak for the entire rationale for this position, his all in move in at the beginning of 2013 coincided with the major ramp up in Fed QE3; so it should be of little surprise that a contrasting trade is in order as this variable reverses.
To add to the set of signals to watch concerning the movement of funds in the market, I also point to the recent deceleration in margin funding on the NYSE. One month does not make a trend, but as the banner on the graph below states, the latest reported month was one that could portend trouble ahead.
Although bank lending has been slow to recover in many sectors since the 2008 financial crisis, margin lending on stocks is not one of those under-served markets. I am particularly drawn to the typical sharp run-up in margin debt in the 6-9 months preceding almost every market top since 1999. The chart pattern in 1999-2000, 2007-08 and 2013 into early 2014 are very similar in terms of the rate of change before a pull-back is observed. The sell-off in the high-flying growth stocks in the NASDAQ (NASDAQ:QQQ) with sectors like bio-tech (NYSEARCA:XBI) and small cap growth (NYSEARCA:IWO) (NYSEARCA:VBK) (NYSEARCA:IJT) being particularly hard hit. Marquee internet names like Twitter (NYSE:TWTR), Facebook (NASDAQ:FB), LinkedIn (NYSE:LNKD) and Amazon (NASDAQ:AMZN) also took large hits to market capitalization, particularly since the first of March. Currently the window for achieving large capital gains on these names looks like it is about to be closed until further notice.
Is there a Preferred Option over Investing like Belgium?
The question many investors are struggling with right now is should I run from the increasingly volatile expensive stock market and hide in expensive U.S. Treasuries or just ride out the volatility. Pick your poison. Both of these markets are suffering from the same problem - excess market liquidity against the back drop that the liquidity will dry up as we head into 2015. Since the Treasury is not currently competing in the market for funds, the present price point on Treasuries, in my opinion, is not an economic signal. It is a price level set to satisfy the needs of the U.S. Treasury. The rationing effects from the Fed policy have caused unsustainable valuations in both the Treasury and the equity market. As the year progresses, I expect stress on equity values as the market begins to accommodate the actual needs of the Treasury without the Fed support.
The best strategy in this market environment is to lean toward value over growth, and accumulate investment grade higher dividend or coupon bond options as they become available. Re-deploying market profits from the run-up in growth plays into large-cap value-dividend plays like Verizon (NYSE:VZ), Exxon (NYSE:XOM) like Warren Buffett to ride out the market adjustment seems like a decent option. I suspect, however, that even this trade is likely to be taken down a notch or two as the monetary illusion fades.
Another option that might work well to protect your gains is to search for preferred stocks with higher dividends that have a good chance to maintain stable value as the stock market trades sideways or down and interest rates begin to return to normal. One preferred stock I currently like is offered by Public Storage Inc. (NYSE:PSA). The REITs most recent offering (PSA.Y) pays a 6.35% coupon and is exchange traded with a value as of close on 5/16/2014 slightly above par at $25.45. It is one of the few recent initial offerings that I have found that is both investment grade (A3) and has a yield above 6%.
You can find other investing options I currently see as relative values in my previous Seeking Alpha article.
The strategy I am currently avoiding, investing like Belgium. Buying short-term Treasuries at near 0%, 10-year U.S. Treasuries at 2.5% or 30-year bonds at 3.4% is charitable giving to the U.S. government without a tax deduction. Unless you view your investment portfolio as a subsidiary of the Red Cross, this strategy is probably not the best idea right now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long PSA preferred stock.