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March 15, 2005

Rates Rise as Credit Markets Receive Smaller Treasury Purchases
by Bud Conrad

The Foreign Connection Carousel

This week I take a bigger view of how the credit markets work, to put into context the specific measure of foreign custody holdings. Credit markets, like any market, are driven by supply and demand. Suppliers of credit are bond buyers, and the demand for credit comes from the debt issuers. All participate in the credit pool of the bond market.

The Connection Carousel diagram above highlights key connections in today's credit market. The heavy lines emphasize how interconnected are major worldwide flows. The circle starts with the federal government providing additional money to the US economy in the form of federal deficit spending. Consumers and businesses spend this extra money. Consumers expand their ability to spend by borrowing money against their houses, and that allows them to buy not only US products, but also a great deal of attractively priced imports. The foreign producers take the dollars they receive from exports to the US and exchange them into their home currency at their foreign central banks. The central banks buy the Treasuries that were issued by the US government to fund the original deficit, making the connection complete. The link I have been focusing on in this series of reports is the purchases by foreign central banks, as they provide a large part of lendable funds to the US credit market. These central banks have been buying Treasuries and Agencies to support the dollar so that US consumers can afford to make foreign purchases. The US dollar has been the reserve currency of choice for the world central banks, accounting for 60% to 80% of the backing of their currencies. As long as the dollar remains the respected medium for world exchange, and retains its value, it is a sensible investment for them. These central banks are not required to buy US Treasures, but it is the most convenient and justifiable purchase.

The BIS reported Tuesday (03/08) that Asian central and commercial banks held only 67% of their deposits in dollars as of September 2004, down from 81% in the Q3 2001. The big change is India, which went from 68% to 43%, while China went from 83% to 68%, albeit mostly before Q3 2002. The BIS had earlier reported that Middle Eastern central banks had cut dollar holdings from 75% to 61.5% of total foreign deposits in the same period. Central bankers are questioning the wisdom of holding so many dollars, and could shift to other currencies. But doing so could hurt their holdings, because the shift itself would drive the dollar down. Foreigners hold over 40% of all US government debt. These shifts are far from dollar friendly, and the rise in rates is consistent with a need for higher returns to cover currency depreciation expectations. The situation is considered unsustainable by traditional economic analysis – the US cannot simply go on buying more and issuing paper dollars to foreigners in payment. At some point the central banks will see that the purchasing power of those dollars is decreasing, and they will stop holding so many. If any link in the chain goes off course, interest and exchange rates would be the first indicators of instability. But, so far, the recycling of US trade deficit has shown no serious sign of unwinding. The dollar has weakened, but interest rates have not moved much. I am watching closely to see if economic tradition will force a major change in either of these measures.

Today (0/10/05)
The trade deficit grew to the second highest ever at $58.3B for the month of January. That's an annual deficit of $700B. The connection above implies an equivalent demand for foreigners to loan us that amount. Imports from China increased 1.9% in January from December, to $17.9 billion. Chinese imports rose 27% year-over-year. There will be some limit as to how much foreigners will continue to loan us, and it seems we are close. A big spike in oil could make this worse, as we have no choice but to pay.

It was announced yesterday that the U.S. budget deficit widened to the biggest monthly gap ever on surges in military and Medicare spending in February. The $113.9 billion monthly shortfall is more than the deficit of $96.7 billion in February 2004. As this is cycled through all the parties of the carousel, the connections continue.

Yesterday there was a new 10-year Treasury auction from the US government to extend its borrowing noted above. It did not surprise the market. The bid to cover was adequate. But the notes carried a yield of 4.504%, which is sharply above the 4.049% on the notes sold a month ago. This is the direction that my analysis has been forecasting. I have focused on foreign purchasing. The indirect bidders in this auction provide some idea of how active foreign central banks may be in buying US debt. While not exactly comparable to the custody holdings, they are a useful indicator. Indirect bidders, which include foreign central banks, bought only 11.7% of the notes, less than their 28.5% share a month ago.

This week, the increase in custody holdings at the Federal Reserve (purchases of Treasuries and Agencies by foreign central banks), was small, only $1.6B. See my article of February 14, 2004, where I describe this analysis in more detail. The chart below updates the view. A key in this is that the rise in rate, shown inverted in magenta, is up, as expected.

The custody holdings are only a portion of the total foreign investment in the US. On March 15 we will get a more complete monthly report for January in the Treasury International Capital (TIC) system.

Since we already have the weekly data from January for custody holdings, we can estimate what the TIC data may show. Custody holdings, especially of Treasuries are not growing as fast as before, so we can estimate that the TIC data may reflect this slowing. I make a calculation by assuming that overall foreign purchases stay at a similar ratio. The ratio of all Treasuries bought by foreigners (as measured by TIC), to the custody holding, is about 60%. For January, the custody purchases were smaller. Applying this percentage suggests that Treasury purchases will be $10B to $15B, whereas they have been running around $15 to $20B. Similarly, the Agency purchases in custody are only 20% of total, but they have not fallen as much, possibly indicating $15B to $20B of Agency purchases for January, which is in line with recent history. Looking further forward to February, we already have an early indication, which shows foreigners returning to buy, so the slow-down we will see in January data should not be taken as a complete change in the cycle. The combined result suggests a drop in foreign purchases, and that suggests interest rates could still be pressured upward.

Bud Conrad

Mr. Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard. He has held positions with IBM, CDC, Amdahl, and Tandem. Currently, he serves as a local board member of the National Association of Business Economics and teaches graduate courses in investing at Golden Gate University. Bud Conrad has been a futures investor for 25 years and a full-time investor for a decade.