I read an article on January 23rd, Hedge Funds Risk Treasuries Wipeout After Bearish Bets Soar, published by Bloomberg.com where analysts at JP Morgan Chase's Jay Barry says "fast money" speculative positions will be hurt badly as Treasuries (NYSEARCA:NASDAQ:TLT) (NYSEARCA:NASDAQ:SHY) (NYSEARCA:NASDAQ:IEF) (NYSEARCA:NASDAQ:IEI) (NYSEARCA:BATS:GOVT) decline in the intermediate future. The investment thesis is based on the fact that hedge fund short interest in the 5 year Treasury (NYSEARCA:NASDAQ:SHV) (NYSEARCA:NYSEARCA:TBT) is currently at a very high level and the expectation is that these bets are almost always a contrarian indicator as they eventually are overwhelmed by Institutional investors who from a dollar volume standpoint far outweigh the hedge fund positions.
The market expectation in the article is logical, and has certainly worked as a trade position virtually without fail over the past 25 years, particularly when Treasuries rise for any length of time longer than 6 months. And if you look at the chart below which shows the Treasury yield curve change over the past 6 months, you are probably tempted to agree with the viewpoint based on the retracement rally in Treasury rates that began post the Fed rate hike in mid-December of 2016.
I currently am skeptical that the move higher in Treasury rates is even close to the market top at this point in time, at least until there are clear sign the "Trump Rally" is going to collapse.
In my market analysis, late year and early 2017 portfolio re-balancing did cause an Institutional bid in the Treasury market and a retracement rally up to the week before Trump's inauguration. However, the market is stubbornly remaining in the current 2.50% range on the 10 year, and appears poised to break higher as stocks move even higher post the Trump inauguration.
I make this bold statement, in contrast to JP Morgan's call, because the fundamental reason that pushed rates to the cyclically low levels experienced in early July of 2016 has now been broken and pushed into reverse, and the Trump election marked a watershed moment which sent the interest rate trend in the opposite direction. At the center of the trend reversal is China, and I share data in this article that show that US Treasury selling by China is the biggest contributing factor behind the large move in rates from July through mid December of 2016. I expect this trend to continue in the intermediate term with the driver for further upticks in US Treasury interest rates being the "Made in America" trade policy which is the centerpiece of the Trump administration, and possibly foreign policy conflicts.
Large Foreign Treasury Sell-off Drives 10 Year Rate Rise
Much of the press concerning recent interest rate increases tends to monotonously focus on "inflation expectations" and whether "economic growth" can support Fed rate hikes. Given the Federal Reserve mandate to fight inflation and encourage US full employment, the tendency is understandable. However, the Treasury bond market, particularly the long end of the curve, in my experience is much more supply and demand driven as opposed to expectation driven. The U.S. Treasury market is the fundamental basis for the size of the U.S. money supply, but additionally since 1971 it has become the collateral pool on which a large majority of international trade is backed and settled. As a result, supply and demand for Treasuries, both domestic and international, is a key factor determining the market rates for longer term Treasuries. Simply reviewing the growth and inflation characteristics of the US economy can be very misleading for someone making a decision about whether to invest in US Treasuries at any given time.
I make this long prelude because the data over the past 6 months, when the 10 year US Treasury note increased 88 basis points, is heavily correlated with one primary factor. That factor was not inflation or US economic growth expectations, although the press is keenly focused on telling the story as if these factors are the drivers. As you can see in the graph below, the primary factor has been selling of Treasuries in large quantities by foreign entities, both sovereign and enterprise. According to the latest TIC data released by the US Treasury, US Treasuries owned by foreigners showed a decline of $335.8B from June through November of 2016.
Based on my review of the historical data dating back to 1967, there has never been selling pressure in this dollar magnitude from foreign entities in the US Treasury market. In fact the closest comparable time period was November 1999 to March 2000 when foreign ownership declined by $199B. As a percentage of total ownership, the 2016 decline so far has been -5.66%, whereas the year 2000 decline was a much larger -18.6%. The big difference between the two time periods is that foreign entities currently own over 42% of publicly traded US debt, whereas in the year 2000 they owned only 30%. The US publicly traded debt in March 2000 was also far less at $3.56T versus $14.4T today, a whopping 4 fold increase in just 16 years.
In the year 2000 the 10-Year Treasury note, after rising from 5% to 6% in 1999 leading up to major foreign sales at the end of the year, continued higher to peak at 6.79% on 1/21/2000, before beginning a decline that lasted for many years. History shows that the stock market eventual peak later in the year 2000 and the ensuing multi-year economic slowdown chased money from domestic and international riskier assets back into US Treasuries as a safe haven.
Why should investors care about a seemingly trivial financial statistic like how quickly foreign entities are selling US Treasuries? - Because the figure is a key barometer for the future direction of the US financial market. Since the early 1970s, US debt purchases by foreigners have typically remained positive through time if looked at over a 5 month interval to smooth out short interval anomalies (See blue line in the chart below).
However, when foreign entities as a whole become net sellers of US Treasuries (See red line below 0%), there is a clear historical pattern of upward pressure on the Treasury yield curve and the 10 year T-Note (See the short cycle peak year and month in 10 year Treasury rates in red).
These time periods also very closely align with some of the most dramatic declines in the stock market, including 1969-70, 1973-74, 1981, 1987, 2000-02, and 2008.
In the second half of 2016 foreign ownership of US Treasuries broke down dramatically, and the 10 year rate has responded upward in line with the historical pattern. The big question for investors and the US financial system is whether the sell-off pattern will subside, or is it just the beginning of a worsening trend?
Who is selling US Treasuries in Big Way? - China
Given the high correlation between long-term Treasury (NASDAQ:NASDAQ:VGSH) (NASDAQ:NASDAQ:VGLT) (NYSEARCA:NYSEARCA:SCHR) (NYSEARCA:NYSEARCA:TBF) (NYSEARCA:ITE) (NYSEARCA:NYSEARCA:TLH) (NYSEARCA:NYSEARCA:EDV) (NASDAQ:NASDAQ:PLW) rate movements up through time and the selling pattern of foreign entities, it is instructive to review what countries did the most selling of US Treasuries in the second half of 2016. Probably not a surprise to many investors reading this article, it is China. From the beginning of July through November 2016, China sold $191.5B in U.S. Treasuries, which amounted to 57% of all net sales. As a reference, Chinese entities owned $1.24T in UST's when they began selling. They sold 15.4% of their Treasury holdings in 5 months, a considerable change.
The remaining concentrated sellers were based in Belgium, a country which is a known proxy location for China US Treasury market activity. In other words, China's sales were likely even higher over the time period. Other major sellers were located in Japan and the U.K. One of the interesting aspects of the financial markets during this time period is that the US Dollar strengthened, while the currencies of China, Japan and the U.K. all weakened on a relative basis.
Typically I would expect a major financial account run on the US Treasury would bring about a dollar weakening scenario. However, the currency market responded to the growing positive short-term interest rate differential between these countries on the prospects for Fed interest rate hikes, leading to the dollar to get even stronger. Over this time period, the data show that private investors in the US primarily picked up the gap in the US Treasury financing needs, as the US continued to borrow at a rate of over $100B per month.
The $2.0T in excess reserves in the financial system created by the Fed QE during the Obama administration declined by over $145B over the time period and an additional $221B in the month of December. The major decline most likely reflects money being put to work by private institutions and investors to cover the US debt financing gap during the time period. The Excess Reserve backstop currently sitting in the US financial system may be tested to finance the Trump agenda very, very soon, particularly if as expected the virtuous flow of International funds into US fixed income markets continues to run dry.
Curious Timing - Over $65B in China US Treasury Sales in November
The data which shows large volume selling of US Treasuries gets even more interesting when you put the spotlight specifically on November 2016, the month Trump was elected. During November, the total sales of US Treasuries by foreign holders were $96.2B. Of that amount, China accounted for 69% of net sales as their Treasury ownership declined by $66B.
Japan also was a large net seller in November at $23B. However, Japan on a year over year basis did not significantly reduce its $1.1T in US Treasury holdings.
The timing of the high volume in Treasury sales by China is curious and is worth trying to understand further, particularly given the current impact on US Treasury yield curve and most likely the overall worldwide financial system if it continues.
Why is China Selling US Treasuries - And, Will the Selling Continue?
The long end of the US Treasury market is witnessing rates going up, and the fundamental reason is largely tied to foreign entities selling Treasuries in large quantity, particularly China. The question is, why now, and when will the trend stop or even reverse?
The Treasury selling trend began prior to the US election, so the explanations on why it is happening cannot with certainty be linked directly to Donald Trump's election. Most of the financial information I have reviewed tend to support the fact that a large part of the pre-election decline in China's Treasury holdings can be linked to financial account "error and omissions" outflows, typically a catch all category for "Capital Flight." There is also evidence of an increase in large dollar overseas acquisition activity by China state owned entities. A good example is the $43B acquisition of Sygenta by state owned entity ChemChina in 2016 which recently closed.
There is also the likely possibility that many companies that borrowed at low US dollar based interest rates to cover operations based in Yuan were inappropriately hedged as the dollar strengthened and the Yuan depreciated. This scenario has likely caused the need for many of these loans to be called and re-structured in Yuan to avoid further currency risk if the Yuan continues its downward move. There is clear data that point to debt repayment from interest rate arbitrage arrangements being a contributing factor to China reserve sales in 2015, but not in 2016.
10 Year Treasury Likely to Rise as Long as the Trump Rally Continues
All of the likely reasons that China would sell large quantities of US Treasuries since July of 2016, however, don't come close to explaining the spike in selling in November 2016. I currently categorize the latest selling by China as a pre-emptive message to the incoming Trump administration which might be worded as follows:
"We presently have the ability to move the interest rates on you government debt higher and our currency lower in the process, to the detriment of your goals as President. If you press us on Taiwan, island building in the South Pacific and our trade practices, your ability to finance your government and the functioning of your capital markets will become more and more difficult."
Sound far-fetched? If a better explanation exists, I welcome the data. I seriously doubt the Chinese sat in a room in Beijing and debated their expectations for US inflation and economic growth in their decision making process to hit the sell button on $66B in Treasuries in November of 2016.
I currently view the Treasury rate spike immediately after Trump's election as Round 1 of a longer term trend which will see US Treasury rates return to and possibly even over-shoot historical norms of 4% on the 10-Year Treasury. In the process there will be ups and downs, but the long-term cyclical trend down in Treasury rates from 1980 through 2016 is over as long as the Trump economic plan is being followed. As the Trump stated goal of "Making goods in America that are consumed in America" is implemented, the virtuous flow of international dollars to fund the US debt will decline on a relative basis. However, federal spending levels are likely to grow faster, not slower than the previous 4 years as entitlements continue to expand to cover aging Americans, infrastructure spending is on the table and defense spending needs are going up, not down.
Mix this likely scenario with tax cuts and you have a recipe for an increasingly large supply of US Treasuries against a dwindling demand pool. If the Fed intervenes as this scenario unfolds, and they will, I don't expect it will be as a buyer of US Treasuries…
Eventually the "Trump Rally" will look more like the "Trump Set-up"; but until this happens, the US Treasury yield curve will continue to lift higher across all maturities. In the current market, keeping Treasury duration short in your bond portfolio (NYSEARCA:NYSEARCA:FTSD) SHY) (NYSEARCA:NYSEARCA:TUZ) (NYSEARCA:SST) is the only rational investment choice in my opinion.
Daniel Moore is the author of the book Theory of Financial Relativity: Unlocking Market Mysteries that will Make You a Better Investor. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
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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: My bond exposure in low risk bonds is currently very short duration, but I am not short the Treasury market.