US bond lovers wish the new US administration will fail to deliver on its extravagant fiscal expansionary promises and yields will be dragged down again. However, they should rethink what they wish for, since a significantly weaker than advertised pro-growth policy mix can potentially have bearish effects on US Treasuries (NYSEARCA:TLT). This might happen due to reduced demand for US Treasuries, a large part of which is fueled by the creditor nations' trade surpluses. In fact, the capability of creditor economies to generate surpluses has been severely inhibited, lately, as reflected by the rapidly shrinking portion of US debt in the hands of foreigners. Even the stronger dollar doesn't seem to have the "persuasive" ability to halt foreign selling of US govies, complicating things for bond holders. If the US, being the largest debtor player in the world, fails to implement a much needed pro-growth fiscal policy mix, coupled with a balanced normalization of rates, then its demand for creditor's exports will weaken and the pressures on their currencies will intensify. Should that happen, foreign owners of US Treasuries reduce their holdings further in order to defend their own foreign exchange markets, as well as the integrity of their local financial systems. This interconnected situation makes the possibility of an underperforming US fiscal policy not so rosy for the prices of US Treasuries, contrary to popular wisdom. Long-term yields might not come down as easily as many think, the next time the US economy loses steam, especially in the absence of any alternative mechanism to revive the US major trading partners' surpluses.
Foreigners' Stance Influences US Bond Yield Cycles
Why does a foreign induced selling of US Treasuries impose such a big threat for investors? For two reasons mainly. Firstly, because US trading partners are among the biggest players in the fixed income market, holding about a third of the US total public debt. And secondly, and most importantly, because every major selling wave of US bonds by foreigners in the past has led, or at the very least coincided with, a cyclical bear market in US bonds. The creditor nations are too important buyers of the US debt to be taken out of the equation.
As a matter of fact, during the last 45 years there have been five major occasions during which foreign holders of US debt have reduced their holdings as a percent of the total outstanding value of debt, causing a sustained rise in long-term yields. The average rise in 10-Year yields was 125 basis points over these particular periods. Moreover, four out of five periods saw a steep rise in yields and only one witnessed steady yields.
Source: St. Louis Fed, US Department of the Treasury, Author's Calculations.
Currently we are witnessing the sixth such occasion. The portion of US debt held by creditor nations and emerging economies peaked in Q2 2014 at 34% of the total amount of outstanding debt, and started to shrink since. In Q3 2016 this percentage reached 31.4% in a combination of increasing supply of US govies and net-selling by foreigners. During this period, 10-Year US yields dropped by 93 basis points, from 2.53% to 1.6%. If we assume that the sell-off continued well into Q4 2016, then the yield difference between the start and the end of the period shrinks to minus 8 basis points. This is still shy of the enormous 125 basis points average yield pickup experienced in the respective historical periods analyzed. What this means is that in order for the market to reverse to its mean, 10-Year Treasuries must climb another 125 basis points from current levels, under the assumption that foreigners will return as buyers of US government paper in order to stabile their holdings as a percent of total public debt. Whereas, should they continue to dump US govies well into 2017, the 10-Year yields need to climb even further from a probabilistic standpoint in order to revert to their mean. In such a case, the 3% long-term resistance level of 10-Year US yields could easily turn into a support level to accommodate an extended uptrend in yields. This exposes the great financial dependence of the US economy on creditor economies.
Currency Wars vs Fiscal Policies
The US needs to finance its excessive consumption, and soon-to-become excessive fiscal spending, with an uninterrupted flow of creditor nations' trade surpluses towards its government paper. When the growth rate of these surpluses is put in jeopardy in contrast to an exponentially growing US public debt, the fixed income starts to feel the breath of the bears. President-elect Donald Trump has promised to unleash a gigantic fiscal stimulus program, a sweeping tax reform and deregulation in order to jump-start the growth engine. A careful design and consistent execution of this massive pro-growth intervention to the US economy can produce long-lasting income effects. Among these effects, the boost to disposable income and business investment in infrastructure will certainly stimulate the demand for imported goods and services. Creditor nations are the first in line to benefit from this increased US demand for their goods, while the emerging economies among them could witness stabilization in their currencies and an improvement in their trade balances.
Under such light, a successful implementation of Trumponomics will have the capacity to revive the trade surpluses of the US economy's major financial backers and result in a new wave of Treasury purchases, putting a floor under falling bond prices. Barring any protectionist extremity, the fiscal hand has the capacity to achieve what the prolonged emerging markets' currency devaluations have failed to do; pick-up the slack in international trade and restart a new cycle of increasing participation of foreign holders in the US Treasury market. This holds because the income elasticity of US imports, i.e. how much imports increase due to domestic income gains, is far greater than the price elasticity of US imports, i.e. how much US imports react to devaluation of foreign currencies. In simple terms, every dollar spend fiscally gives much more bang for US trading partners buck than what their currencies' devaluation can achieve in terms of reversing the downtrends in their trade surpluses.
A failure by the new US administration to implement what was pledged during the election campaign, on the fiscal front, would just accelerate the already reduced ability of the US main trading partners to accumulate foreign reserves and invest in US Treasuries. From China and Saudi Arabia to Brazil, the underperformance of Trump's economic policy could just accentuate the pressure on their currencies, and spark an even greater USD funding shortage. In this respect, most of the US trading partners increasingly turn their financial priorities away from the accumulation of US Treasuries, not out of choice but out of necessity. In other words, they are increasingly forced to divest of us govies simply to defend themselves. It's the deceleration of their international trade that restrains their demand for US paper.
Having said these, US bond investors who wish for a fiscal deadlock should rethink their reasoning. This time, a less robust US economy will not necessarily be in US bond's best interest. The US public debt might have already passed its tipping point, being in greater and not lesser need of creditor nations' assistance. If President-elect Trump wants to take advantage of the still historically low US borrowing rates, he better does it fast and in the correct pro-growth and all-inclusive way. Otherwise, bond lovers could easily turn into bond haters.
Disclosure: I/we 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: The views expressed in this article are solely those of the author, provided solely for informative purposes and in no case constitute investment advice.