While the Friday-Monday effect had stocks extending their rally, an equally large trend away from US Treasuries is affecting traders' calculations ahead of this week's Congressional testimony by Fed Chair Janet Yellen.
By Vikram Rangala
Monday, February 13, 2017
The S&P 500 Index made another record high on Monday, reaching 2,328.68 in an extension of the rally which marked last week's global equity markets. President Donald Trump signaled last week that he would soon unveil details of his pro-growth policies and had cordial meetings with the leaders of Japan and Canada, adding to investor optimism.
Also boosting investor confidence for the moment is a consensus view—supported by comments from Fed officials—that interest rates will not be raised at next month's FOMC meeting. In the current climate, with a new and some might say unorthodox administration settling into office, investors are looking for steadiness.
Searches of recent news headlines and earnings reports have found two words becoming prominent: "uncertainty" and "optimism." In the news, the word "uncertainty" has appeared more often in the past year not just in articles about US politics, but about Europe's security, the future of NATO, and whether Russian hackers will attempt to influence upcoming elections in France and Germany the way they did in the US. Outside of politics, the word "uncertainty" appears in news about trade and protectionism.
That didn't stop companies from using the other hot word in their earnings reports this past quarter: "optimism." A record number of companies, both profitable and unprofitable, expressed their optimism about the coming year. Some of this is spin; nobody is going to say they are pessimistic. But despite the uncertainty about trade and fiscal policies, companies seem to have focused on the prospect of corporate tax cuts and increased spending on infrastructure and defense, coming on top of the long streak of job creation and slow but steady reflation of prices.
One group, however, is not as optimistic: foreign holders of US debt. About 43% of US government debt, mostly in the form of Treasury Notes, Bills, and Bonds, is held by foreign entities, the biggest being Japan and China. The number was as high as 56 percent in 2008, but came down as the US economy recovered.
Now, China's holdings are at a seven-year low and Japan has reduced its investments in recent months as well. Is that good? Yes and no. Yes if it means domestic demand took its place. But no (and more likely) if it means US Treasury bonds are less attractive.
Generally speaking, as demand for US Treasuries decreases, the yield (the return investors can get) increases. They have an inverse relationship. This is true of any debt instrument, including corporate or municipal bonds. An easy way to think of it is, if demand is low, they'll raise the ROI to make them more attractive. And if demand for the debt is high, they don't need to pay out as much to get people to buy it.
The yield had been trending up last year, but increased domestic demand kept it unchanged for the year-to-year 2016. There is also an inverse relationship of price to yield. If you're looking to buy a bond, you want to get it for a low price, meaning a high yield. But once you're holding those bonds, you want lower yields (plenty of demand) so the bonds you're holding go up in value and can be sold for a profit.
In this situation, the key point is that higher yields make the big creditors, who already hold trillions in US bonds, less happy because their holdings now aren't worth as much.
In 2017, two factors may cause yields to rise and demand to drop. First, if and when the Fed raises interest rates, bond yields are almost certain to rise with them. Chair Yellen will talk about that to Congress this week. Second, bonds are often used as a hedge against the volatility of the dollar. About that, the word from foreign investors is already out.
With all of the uncertainty about future policies on spending, taxes, and trade, the dollar is expected to continue the up and down swings that have become the new normal, with the yen expected to reach 100 yen parity and the euro's future the object of ongoing speculation. European and Japanese banks and funds that hedged their dollar-based holdings with US Treasuries saw near-record (Japan) and record (Europe) losses in those positions.
At a time when markets can be moved by a single tweet and the tweets are coming in a steady, unpredictable stream, those who put their faith in US Treasuries as a safe haven are now looking elsewhere in a large and long-term way. With Angela Merkel facing challenges from right and left in the upcoming German election and the nationalist Marine LePen leading in some French polls, the ECB and private banks are actively looking for new ways to shore up the euro, not just as a currency, but as an idea.
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