For some of us, worrying is a habit; for others, it is a pastime. Those in the first group have found a new cause: the rise in US treasuries yield. From a low of around 4.5% in February, the yield on the 10-year US treasury yield has almost reached 5.0%
The next resistance points are the psychological threshold of 5.0% and the high of around 5.25% in mid-June last year before one starts worrying about a bear market in US treasuries engulfing other financial markets. The fear is that diversification of foreign exchange reserves away from the US dollar by global central banks would aid this process. It’s a misplaced one.
It was initially thought that the US current account deficit drove the other central banks, particularly in Asia and the oil exporting nations, to build up dollar reserves. But, it is hard to continue to paint the US as the villain of the piece as some insist on doing (e.g., Steven Roach, The Economist). After “peaking” at around 7% in December 2005, the US current account deficit-GDP ratio stood at slightly below 5.8% in end-March 2007. Despite this apparent peaking, foreign exchange reserves are still rising and, in fact, at an accelerated pace. Clearly, the locus of the problem is not Washington D.C. Beijing, for example, comes to mind.
International reserves in the developing world are mounting though the US current account deficit is no longer rising as fast. Once a large country with a seemingly limitless supply of labour decided to embark on an export strategy, there was little that other countries, hitherto dependent on exports, could do. They had to maintain their exchange rates at a weaker level, at best, and slow down their appreciation against the US dollar, at worst.
While expanding global growth supported the export upswing, weak domestic demand and investment spending resulted in lower import growth and the associated rising current account surpluses. Combined with investment inflows, this exerted appreciation pressure on local currencies. Central banks had to either accept that or accumulate foreign exchange reserves. Most developing countries opted for the latter.
This configuration looks unlikely to change drastically in the near term. China is making glacial progress in re-balancing its economy towards greater consumption. The export-led growth process and consequent reserve accumulation are likely to continue for some time. So, other countries have no choice but to follow suit.
But, pessimists are not assuaged so easily. Since emerging governments are now talking of launching sovereign funds to invest their reserves globally in riskier assets, there is a fear that they would switch out of US treasuries even if reserves grow. This, too, is a misplaced concern. Their influence is overstated.
Even when they were buying US treasuries aggressively, foreign central banks were unable to prevent the US treasury yields from rising after they bottomed out in mid-2003. They could only help to mute that ascent. Similarly, their role in causing the US treasury yields to rise, if at all, would be equally subdued.
Imagine the counterfactual scenario: Assume the US economy enters into a recession and the Federal Reserve starts cutting interest rates. Would treasury bond yields rise merely because central banks from the developing world opt to buy other assets and not treasuries?
Of course, expectations of rate cuts in the US have abated due to rebounding growth and persistent inflation. At the beginning of the year, interest rate futures discounted nearly four rate cuts in the US this year. Now, it is barely down to one. If this trend gathers momentum, the Federal Reserve faces the spectre of rebounding growth and sticky inflation. That might cause rate cut hopes to be replaced by rate hike expectations, which is surely negative for US treasury yields.
In that situation, one would actually see foreign central banks increase their purchase of US treasuries. Their export-dependent growth model would collapse if the American consumer buckled under the assault of rising US treasury yields.
Second, with reserves continuing to rise because of growth driven by global rather than domestic demand, the dollar amount required to be directed into buying risky assets is substantial and would not be easily digested. Nationalist sentiments would not allow the acquisition of risky assets in the same size and speed as US treasuries were acquired. Therefore, they would step in and stabilize yields instead of allowing these to rise.
Thus, rising US treasury yields may cause some palpitation to risky assets but would not induce a heart attack. The People’s Bank of China and others would ensure that, unless they are overwhelmed by the leading central banks responding to recovering economic growth and sticky inflation.
(V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Your comments are welcome at email@example.com)