(Bloomberg) -- Owning $1 trillion of U.S. Treasuries just doesn’t mean as much as it used to.
The threat of new U.S. steel and aluminum tariffs and the resulting departure of top White House economic adviser Gary Cohn have raised the specter of a trade war, and President Donald Trump’s administration is also said to be considering a range of curbs on China. It’s only natural to ask whether some of America’s largest creditors would stop buying Treasuries in retaliation.
Just a whiff of a pullback from China, which holds almost $1.2 trillion of Treasuries, gave the market jitters at the start of the year, and the U.S. can ill afford much steeper borrowing costs as the budget deficit swells.
What generally goes unnoticed, though, amid the 12-zero numbers, is that China’s relative share of the market for Treasury notes and bonds is near its lowest since 2005, at 9.4 percent. For Japan, which owns $1.06 trillion, its 8.4 percent share is the smallest in at least 18 years. In other words, they haven’t kept pace with U.S. issuance.
Of course, part of that has to do with the Federal Reserve’s bond-buying program after the financial crisis, which soaked up much of the supply. But the U.S. central bank’s holdings barely budged from late 2014 until last year, and have since fallen, while the Treasury market, including bills, has grown by more than $2 trillion to $14.7 trillion. What that means is, trade war or not, big foreign buyers have already been slowly stepping back.
“The relative importance of Japan and China as holders of U.S. debt has declined,” though they still own more than enough to move markets, said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities in New York. If overall holdings don’t move up much in the coming years, “these numbers will shrink further, just given the trillion-dollar deficits we’re planning to be running.”
At its peak, Japan owned almost 25 percent of all Treasuries back in 2004, while China’s holdings grew to a high of around 20 percent in 2009. Over the past six years, reported holders in Ireland, the Cayman Islands and the U.K. have been the largest foreign buyers of U.S. debt, Treasury Department data show.
Few bond traders really expect China or Japan to abruptly sell Treasuries en masse. After all, their stashes are so large that any such move would likely crater the value of their own holdings.
“I’ve never been of the view that China would ever intentionally say, ‘Oh let’s just sell Treasuries and spike U.S. rates’ -- because how does that help them?” said Eric Stein, co-director of global income at Eaton Vance Corp. “It’s mutually assured destruction in the U.S.-China relationship.”
Going Slowly
Foreign officials are more likely to pull back slowly.
Consider January, when Bloomberg News cited senior Chinese government officials as recommending slowing or halting purchases of Treasuries. Benchmark 10-year Treasury yields rose about five basis points in less than an hour after the initial report on Jan. 10.
Though China’s State Administration of Foreign Exchange dismissed the report, saying in a statement that investments are decided by market conditions, it speaks to the gradual pace at which a country with such significant holdings would need to exit.
Major holders also have few alternatives, particularly China, whose $3.1 trillion stash of foreign-currency reserves is the world’s largest. That money has to go somewhere, but many developed markets, such as Japan and Europe, are distorted by quantitative easing.
Private Japanese investors, on the other hand, have been purchasing more bonds from countries like France and Germany because the hedging cost is lower than in the U.S. market. They lose more than 250 basis points of yield on Treasuries after hedging, while they pick up over 25 basis points when converting from yen to euros, according to data compiled by Bloomberg.
Treasuries have withstood pullbacks from both China and Japan over the past two years. But with auction sizes only growing in the coming years, and the Fed paring its own holdings, the U.S. likely needs them to at least keep their share of the market steady. That’d be a hard ask in the midst of a trade war.
“Their marginal importance might be even higher” because of imminent U.S. budget deficits, TD’s Goldberg said. “Especially if the No. 1 and No. 2 holders decide they want to use their holdings of Treasuries as retaliation. It’s something that has been threatened before -- I think the U.S. is well aware of it.”