Low Yields Could Also Prove ‘Transitory,’ Buying Patterns Signal

(Bloomberg) -- Federal Reserve Chairman Jerome Powell describes the latest bout of low inflation as caused by “transitory” factors. If he's right, U.S. Treasuries may be particularly vulnerable to a sell-off, according to an analysis of who's been buying them lately.

Even after the Fed stopped accumulating Treasuries in 2014, continued asset purchases by global central banks sustained an “artificial” base of support for the securities by pushing investors in Europe and elsewhere into American government debt, according to Oxford Economics. That largely ended last year, as the European Central Bank and Bank of Japan tapered their quantitative easing alongside the Fed's balance-sheet reduction.

As the federal government ramped up debt issuance, U.S. funds filled the gap, “absorbing the largest amount of domestic securities on record,” Guillermo Tolosa, an economic adviser to Oxford Economics Ltd. who analyzes global capital flows, wrote in a May 2 note. The “unregulated” investors, including hedge funds, that have taken up much of the supply “tend to be more price sensitive,” making Treasuries more vulnerable, Tolosa wrote.

Low inflation means current bond valuations should last for now, but that could change as “the ongoing recovery in the Chinese economy could become a reflationary force,” Tolosa wrote. “U.S. markets have come to be particularly vulnerable,” thanks to recent flows being dominated by short-term funds. “The unwinding of such positions could have ripple effects on global bond markets.”

Among other dynamics that have made Treasury demand less solid, Tolosa listed:

• China's capital outflows have focused less on Treasuries and more on foreign direct investment and loans, such as those extended through the Belt and Road Initiative
• Similarly, Japanese investors have been tilting toward other types of external assets than bonds
• European investors' “high exposure to foreign securities” will see them re-balance portfolios toward domestic debt

Macroeconomic developments “are key drivers of pricing outcomes, but the sensitivity of prices to macro news changes a lot with an adverse flows backdrop,” Tolosa wrote in a follow-up email. “Hence the elevated risk now to global bond markets.”

To contact the reporter on this story: Christopher Anstey in Tokyo at canstey@bloomberg.net

To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Adam Haigh, Shikhar Balwani

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