By Prof Jayanth Varma
During the Great Moderation, the US Treasury market came to be dominated by official investors – Asian central banks and the reserve funds of oil producing countries. During the last couple of years, these flows have gone into reverse. With oil around $50 a barrel, most oil producers are liquidating their reserves rather than adding to them. In Asia too, reserve accumulation has slowed down if not reversed with China in particular depleting its reserves as it deals with capital flight.
The Role of Private Investors
The massive selling by official investors has been more than balanced by large scale buying by private investors. Some of this is clearly visible in the official data (see for example, slide 10 in Torsten Slok’s presentation at the Brookings event last month on “Negative interest rates: Lessons learned…so far”). I suspect that the official figures understate the true extent of this shift because at least a part of the official selling would be from offshore vehicles that are not clearly identifiable as official holdings.
Implications for Volatility in US Treasury Yields
If this trend continues, I believe this could have serious implications for the volatility in US Treasury yields. As long as the net buying was dominated by price insensitive reserve managers whose mandates restrict them to very safe assets anyway, the volatility of yields would have been quite muted. But the private buyers are much more unconstrained in their portfolio choices and are also much more sensitive to risk-return opportunities in the market.
For example, a large part of Chinese capital flight amounts to Chinese external assets moving from the government (PBoC/SAFE) to private investors.
Unlike the PBoC or even SAFE, private investors can invest in corporate bonds, equities and real assets anywhere in the world, and have no special preference for US Treasury.
In today’s environment of flight to safety, US Treasury is well bid on the basis of risk-return expectations. But that could easily change and then long term US Treasury yields might have to move a lot to equilibriate supply and demand. At that point, we will see the true consequences of US Treasury becoming a playground of hot money instead of a long term store of value.
Prof. Jayanth R. Varma is a professor of finance working mainly in the field of financial markets and their regulation. He is currently a director on the Board of Infosys BPO Limited and Gujarat International Finance Tec-City Company Limited. He has carried out extensive research in the field of Indian financial markets and finance theory and published extensively in Indian and international journals. He has also authored extremely popular books on portfolio management and on the Indian securities scam.
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