China crisis for US bonds?

Tim Bond, head of Global Asset Allocation at Barclays Capital, wrote a well-timed piece panning bond markets in the FT on Thursday last week. He argues that bond yields are much lower, and yield curves much flatter than would normally be expected given the current economic environment, and estimates that long dated bond yields are around 1% below equilibrium value. This has occurred because of a combination of foreign exchange reserve growth and regulatory changes that forced pension fund investors to purchase more long dated assets.

As a result of this demand/supply imbalance, bond yields are very low. Meanwhile equity earnings yields remain reasonably high, spurring companies to releverage. Finance directors with any sense have reacted to the market conditions by issuing debt very cheaply, and buying back their equity. Those that haven’t releveraged have found hungry private equity investors circling their firms. We’ve commented quite a bit about corporate releveraging in our blog (such as here).

Tim Bond believes that foreign exchange reserve growth is prompting global reserve managers to diversify away from low risk bonds and into higher risk assets, and suggests that China will redirect some $300-400bn away from bonds and into equities. Foreign exchange reserves certainly go some way to explaining why bond yields remain so low, but the projections for China appear a little aggressive. The US Treasury publishes this lengthy analysis of foreign ownership of US securities. It shows that overseas investors own more than half of the outstanding US government bond market, up sharply from 22% in 1989. China’s holdings of US Treasuries have risen very steadily from around $80bn at the beginning of 2002 up to $420bn at the end of March, which is second only to Japan’s $612bn. There is little sign of China’s build up of Treasuries slowing, never mind falling back down to 2002 levels, but I agree with the general conclusions of Tim’s article – bond yields have been depressed by significant and continuous Asian central bank buying, but if these foreign buyers stop turning up to the Treasury’s bond auctions this bear market might have further to run.

I see the Chinese buying of US bonds as a form of vendor financing. China produces goods, but doesn’t (yet) have the domestic demand to purchase them. The US consumer has massive demand for goods, but doesn’t have the means to pay for them. So the Chinese give the Americans cheap credit in order for them to keep buying, and keep the Asian factories in business. As long as the current global demand imbalances persist this should keep the US bond market stable. But what happens if Asian domestic demand grows to an extent that they don’t need to rely on the US consumer? Or if European domestic demand finally starts to recover, creating another big market for Asian goods? Finally what about the losses that the Asian central banks are suffering on their US bond portfolios? In this quarter alone so far the Treasury bond market is down 1.2%, so the Chinese will have suffered mark to market losses of $5bn, and the Japanese over $7bn. Might there be a mass running to the door?


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Jim Leaviss

Job Title: CIO Public Fixed Income

Specialist Subjects: Macro economics and fixed interest asset allocation

Likes: Cycling, factory records, dim sum

Heroes: Brian Clough, Morrissey, Neil Armstrong

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