To understand the path forward for U.S. interest rates, it is necessary to review the unconventional monetary policy known as quantitative easing that has helped allow (once unthinkable) near-zero rates to persist. Announced by the U.S. Federal Reserve Open Markets Committee (FOMC) in November 2008, when ~29% of U.S. mortgages were underwater, the first round of quantitative easing (QE1) consisted of more than $900 billion of funds that were used to purchase impaired mortgage securities through June 2010. Emergency funds are widely-credited with helping to stabilize the U.S. economy in the aftermath of the Financial Crisis of the last decade, but they came at a cost: QE1 had the negative side-effect of making U.S. Treasuries (UST) less attractive to their (then) largest buyer, the People Bank of China (PBoC), which stopped accumulating UST after the completion of QE1. The policy shift is reflected in the composition of PBoC holdings, where UST (as a percentage of the total) fell from 74% in 2006 to 54% of in June 2015. It is further evident in the below chart (Exhibit a), where the red-shaded portion delineates the direct UST held by the PBoC and the yellow-shaded area shows UST holdings of the PBoC located in its Belgium-based custodial account with Nomura Securities, where gains from China’s positive trade balance with the U.S. were systematically transferred and converted into E.U. assets. It should be noted PBoC funds held with Nomura Securities were not fully-understood until April 2015, with many assuming the country of Belgium had shifted holdings, but its existence (in retrospect) does explain the strength in the euro currency over the associated time period.
What’s important here is the PBoC became a ‘net seller’ of UST after the FOMC implemented QE1. Officials in Beijing publicly-expressed concern about the negative impact of QE1 on the future value of their $1.4 trillion in UST holdings, and the data shows a clear policy shift. How did the absence of the largest buyer impact the UST market? In a Congressional Review, Morrison and Labonte (2012) explain that “all else equal, Chinese government purchases of U.S. assets increases the demand for U.S. assets, which reduces U.S. interest rates.” Should China stop buying UST, the authors conclude (i) the gap would need to be filled by other (foreign and domestic) investors that would (ii) “presumably require higher interest rates than those prevailing today to be enticed to buy them.” This assessment reflects basic bond math, particularly when the sale of UST by foreign central banks is considered because an increase in supply technically causes yields to rise on new issuances. For context, research analysts at Citi Group equate a $500 billion sell-down in UST, over 12-months, with an increase in yields of 108 basis points (bps) on new issuances, while Deutsche Bank has put forth a slightly different figure, saying monthly declines of $100 billion translate into an increase of 40-60 bps in the yields for new 5-year UST issuances.
Exhibit a. U.S. Treasury Holdings of People’s Bank of China (USD in billions)
Source: Bloomberg News (2015).
But, higher rates did not materialize in the U.S. markets. Events played-out differently because the FOMC introduced two additional rounds of quantitative easing (QE2 and QE3) with funds targeting open market purchases of UST, in addition to mortgage securities, which, together with QE1, expanded the balance sheet of the U.S. Federal Reserve from $890 billion in 2008 to $3.6 trillion. Members of the FOMC have notably chosen other words to describe the two additional rounds of quantitative easing, but one fact is clear: (i) had QE2 and QE3 not been introduced to buy open-market UST, the U.S. Treasury Department would have been compelled to raise the interest rate on new issuances to attract buyers. We can also infer (ii) QE2 and QE3 would have been unnecessary if the PBoC had continued to accumulate UST at the prior period pace. Make sense? The official rhetoric on QE is admittedly difficult to follow, but the situation is straightforward.
With the FOMC having ended QE3 in October 2014 and signaled an intent to raise the benchmark lending rate 4x in 2016, officials are faced with a very different landscape than prior monetary tightening cycles. This is because foreign central banks are selling UST at an increasing rate, marking a massive departure from the preceding 15-year period when the same players accumulated reserves of $10 trillion. Research analysts at Deutsche Bank (Exhibit b) anticipate an additional sell-down of $1 trillion in reserves in 2016. The biggest seller will be oil exporting nations that need to liquidate reserves to meet internal budgets, such as Saudi Arabia that spent $115 billion in 2015. The International Monetary Fund (IMF) is forecasting an additional $450 billion drop in reserves (out of a collective total of $4.2 trillion), while analysts at Goldman Sachs expect capital outflows from oil exporting nations to reach $24 billion per month or $900 billion by 2018. The remaining portion of the sell-down is expected to come from the PBoC, which has foreign reserve levels that are 2x the recommended amount of the IMF, even after adjusting for the $700 billion decline (from $3.9 trillion to $3.2 trillion) from peak reserve level in June 2014.
What does all this mean? Firstly, the FOMC will not be able to move forward with 4 rate increases in 2016; the figure will be closer to 2 and it will occur at the end of the year, if at all. Also, structural changes in the foreign buyer universe for UST imply one of two outcomes: (i) the U.S. Treasury Department will need to raise rates by upwards of 216 bps on new issuances, given the $1 trillion figure from Deutsche Bank and yield estimates from Citi Group, or (ii) the FOMC introduces new monetary stimulus to fill-the-gap and smooth the forward path of interest rates. When the U.S. $800 billion funding gap is considered, a figure that is based on a budget shortfall of $1.1 trillion and $300 billion of annualized UST foreign demand, it’s hard to imagine a scenario where the FOMC does not step in with additional monetary policy, particularly if higher inflation data forces rate hikes later in the year. We are not sure what name the FOMC will use to telegraph the new monetary stimulus – let’s call it ‘QE4’ for now – but it’s safe to say the reversal in tone will be received poorly by the international community, causing the exodus of foreign funds to accelerate. As a result, it seems likely the USD will reach peak strength at the end of the current cycle.
