Tuesday, February 14, 2017

World's Biggest Debt Market Faces Huge Test From Trump

By Tracy Alloway
The Bloomberg View
February 14, 2017

President Donald Trump is a man obsessed by imports, and untroubled by exports.

Since he first hit the campaign trail, Trump has been squarely focused on boosting domestic production by limiting cheap imports from places like China and Mexico and replacing them with homegrown offerings. Much more rarely has he talked about selling those homegrown offerings -- be they Ford Explorers or Boeing 747s -- to the rest of the world.

It’s a curious state of affairs, like encouraging people to cook by banning restaurants. Disconcertingly, Trump’s brand of import substitution is now playing out in the world’s biggest debt market.

Debt is, without a doubt, the U.S.’s biggest export. The U.S. Treasury market is not just worth trillions ($13.9 trillion, to be exact), but also represents the “risk-free” rate against which other financial assets are judged, if not fully pegged. To overstate its importance is difficult: It is huge, big-league -- one of the few markets to which Trump’s brand of hyperbole might actually apply.

And yet U.S. Treasuries have been finding far fewer foreign buyers in recent months -- a trend that has so far been offset by higher domestic demand. U.S. investors have been buying longer-term government debt at a record pace since June, while recent data shows Japanese buyers, the biggest owners of U.S. Treasuries, have reduced their holdings for two consecutive months.

Demand for U.S. Treasuries has moved “from global to local,” Bank of America Merrill Lynch rates strategists Carol Zhang and Shyam Rajan wrote in a note to clients last week, calling the shift “the biggest macro theme” playing out in markets.

That might be music to the ears of market mercantilists, but it comes at a cost.

Adversaries of import substitution have long argued that the strategy boosts short-term growth at the expense of longer-term health. It flies in the face of comparative advantage -- a central tenet of classical economic theory -- and precludes economies from enjoying all of the benefits that come with specialization, including lower prices.

A similar dynamic applies to the transformation of the U.S. Treasury market. While a pickup in domestic demand can initially help offset selling by foreign investors -- such as the People’s Bank of China attempting to stabilize the yuan or Saudi Arabia reducing reserves to deal with lower oil prices -- it may well leave the market more fragile over the longer term.

U.S. pension funds, banks and insurance companies can opt to “Buy American” with Treasuries, but there are limits and there are risks. Those risks became painfully clear during the eurozone debt crisis, when troubled European Union members used central bank liquidity facilities to buy their own debt after foreign buyers went on strike. The move helped them weather the worst of the crisis, but it also became a pressure point as investors fretted over a “feedback loop” of codependency and negative sentiment between banks and bonds.

That feedback loop idea has most recently been revived by Paul Schmelzing, a doctoral candidate at Harvard and a visiting researcher at the Bank of England, who has warned that a sharp sell-off in bonds could be worsened as investors are forced to offload their holdings as they lose value.

Certainly, American investors are buying U.S. Treasuries at a tricky time; rumors of the death of the 30-year bull run in bonds have been much exaggerated, but they are gaining steam. The fact that investors have been buying longer-maturity bonds exposes them to significant duration risk, meaning they’re more exposed to changes in interest rates at a time when the Federal Reserve is expected to raise.

Perhaps more relevant to Trump’s ambitions are the self-apparent limits that a domestically funded budget will put on his growth plans. The president wants to boost fiscal stimulus while cutting taxes -- a plan that will only work as long as the U.S. is able to issue and sell its debt. Few think that foreigners will stop purchasing U.S. debt altogether, but the loss of a significant pool of players will by definition place a cap on the market.


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