- More and more evidence is coming to light that foreign investors have been moving money out of the United States over the past year or so.
- A large part of these funds had been "risk averse" monies brought into the US seeking a "safe haven" due to the financial turmoil of the early 2010s in Europe.
- The outflow of these funds may have significant impacts on longer-term yields, which will have ramifications for the federal government's increased needs for debt funding.
It is reported in the Wall Street Journal that foreign investors have moved on from investing in the debt of the United States government.
Jon Sindreu writes, “The European Central Bank estimates that since 2015, eurozone investors have accounted for more than half of foreign purchases of U. S. debt securities.”
“But in 2017, eurozone investors were consistent net sellers of Treasurys, according to official U. S. data.”
Mr. Sindreu argues that a big reason for this change in heart has been that hedging opportunities using derivatives have declined to the point where this strategy no longer is as attractive as it once was. And, he explains several techniques for hedging positions.
Overall, however, these explanations and some others relating to interest rate expectations and increasing term premiums seem to be stretching for an explanation, something that Mr. Sindreu seems to agree with since “Fed data” suggests that these reasons don’t explain a lot of the change in behavior.
In late 2016 and early 2017, I suggested another reason for the movement of funds out of the U. S. Treasury market. This discussion is captured in my post of February 14, 2017.
In an even earlier post I argued that a substantial amount of foreign monies had moved into the United States in the 2011-2013 period, especially from Europe. These funds were looked at as “risk averse” monies that were seeking a “safe haven” and the “safest” of the “havens” at that time happened to be the United States.
In fact, so much “risk averse” funds entered the United States that the yield on U. S. Treasury Inflation Protected Securities (TIPS) dropped into negative territory and remained there for extended amounts of time while Europe and other areas attempted to get their economic houses back in order.
Rates on these TIPS returned to around the zero-level through most of 2016. However, the presidential election in the United States in November 2016 seemed to turn things around.
In late October 2016, just before the election, the yield on the 10-year TIPS was around 0.07 percent. On November 10, the yield rose to 0.27 percent.
The yield on these TIPS never looked back.
In my post of February 14, 2017, I wrote the following:
“The other factor influencing bond yields that drew less press attention was the rise in the yield on TIPs.”
“The yield on the 10-year TIPs just before the November election was around 0.07 percent. This yield rose to around 0.70 percent in the middle of December with the apparent cause of this rise being an outflow of money from the United States. These "risk-averse" monies had been placed in the United States as a "safe haven" and now, seemingly, were being taken out of the states by investors due to the uncertainty connected with the arrival of the new, Trump administration.”
The yield on the 10-year TIPS dropped back to about 0.40 percent in the middle of February 2017 and has recently moved up to the 0.80 percent level.
Where should the yield on TIPS be?
The theoretical argument is that the yield on TIPS is a proxy for the real rate of interest. In this argument, the nominal rate of interest, say the yield on the 10-year US Treasury note is composed of an expected real rate of interest and an expected rate of inflation. If the expected real rate of interest is assumed to be the yield on the TIPS, then if the current nominal yield is 2.87 percent, where it closed yesterday, and the yield on the 10-year TIPS is 0.74 percent, where it closed yesterday, then one can estimate that the expected rate of inflation for the 10-year time horizon is 2.13 percent.
And, what should the expected real rate of interest be? Theoretically, the expected real rate of interest is assumed to be equal to the real rate of growth of the economy over the time horizon being considered.
Well, during the recent period of economic recovery, which is just over 8 ½ years long, the compound rate of real growth has been 2.2 percent. If, for purposes of discussion, this rate is expected to continue over the next 10 years, how should we relate it to a yield on the 10-year TIPS of 0.80 percent.
Historically, since the government has issued TIPS, the yield on the 10-year TIPS has tended to be a little bit lower than the growth rate that the economy is projected to grow. But, the differential between the expected growth rate and the yield on the 10-year TIPS was never as great as has been observed now, at 1.4 percent (using the 2.2 percent expected growth rate and the current 0.8 percent yield on the 10-year TIPS).
This is where the movement of the “risk averse” monies comes into the picture.
As the financial turmoil in Europe grew in the 2010-2011 period and the "risk averse" monies began to flee the continent, the yields on US TIPS began to nose-dive. But the correlation between the flow of funds and the decline in real yields below zero was extremely close. This movement of funds seems to explain why the yields on the TIPS dropped below zero and remained so low for so long. The flow of "risk averse" funds throughout the world was distorting U. S. yields.
Since the presidential election, the flow of funds seems to be in the opposite direction. The data cited by Mr. Sindreu in his Wall Street Journal piece support this interpretation. The funds “leaving” the United States, therefore, seem to be a result of politics, as much as anything, as European investors - and others - have seemingly lost some confidence in this “safe haven” destination for their monies.
Given that inflationary expectations are what they are and are not assumed to be impacted by the movement in the yield on TIPS, we can provide a justification for higher rates for nominal interest rates.
If the expected real rate of economic growth in the United States is expected to remain equal to the growth rate achieved in the current recovery, 2.2 percent, and the “risk averse” funds continue to leave the U. S., and the yield on the 10-year TIPS comes in at, say, 60 basis points below the expected growth rate, at 1.6 percent, then the nominal yield on the 10-year Treasury note could rise to as high as 3.7 percent. Remember that the current yield is around 2.9 percent.
One can make their own assumptions about what impact the money leaving the United States might have on nominal yields, but whatever they are, they point to substantially higher longer-term rates. And, these rates will be coming just as the government is going to need to issue more and more debt to finance the fiscal deficits that are now on the books.
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