US Treasury Holdings in Asia, QE and USD Strength, 5Y5Y Inflation Expectations

The relationship between Japan’s and China’s holdings of US Treasuries provides another indication of changing international USD liquidity conditions. There is an increasing divergence between domestic and international USD liquidity. Ironically, some of the current USD shortage is a reflection of second-round effects coming on the back of QE.

Concretely, QE has boosted cross-border asset and liability holdings and laid the foundation for ‘commodity dollars’ (a wider definition of petro-dollars) moving into EM and here mainly into Asia,helping to create unprecedented debt piles. As now some of these commodity dollars make their way back towards their origination (e.g., Saudi Arabia issuing USD debt), the cost of the international USD has started to rise. Cross-border asset and liability holdings requiring currency management (which often means hedging)has boosted hedging costs. Commercial USD deposit-funded banks used to arbitrage the rising spread between domestic and international funding costs, but regulation restricted banks’ arbitraging capacity. US prime funds now funding fewer international issuers has reduced the effectiveness of a tool converting domestic into international USD.

Official versus private USD flows: In October, China’s holdings of US Treasuries (US$1.12trn) declined (-US$41.3bn) to the lowest level in more than six years as the world’s second-largest economy uses its currency reserves to support the yuan. Japan overtook China (under the TIC’s official country reporting) as America’s top foreign creditor (US$1.13trn),as its holdings edged down at a slower pace. Currency reserves are the residual of global liquidity and, since China’s capital account has been regulated for long, China runs most of its foreign asset holdings via its reserve managers. In Japan, private holdings dominate. When private demand for USD assets rises and the US fails to increase its international USD supply, for instance by running a wider current account deficit, or increasing international access to US domestic funding tools, then rising private demand for USD-denominated asset leads to a USD shortage.

JPY: Largest mover under USD shortage: This USD shortage has become best visible by the widening cross-currency basis impacting markets in a textbook fashion. JPY should remain the largest mover under the USD shortage for now as rising international USD funding costs have pushed hedging costs higher. We see two effects working through markets. First, Japan’s FX over-hedged foreign asset holders are likely to let hedges expire, keeping JPY on the back-foot. The spread between hedged and unhedged returns has increased by the day, adding to pressures to take hedges off.For the10 largest lifers the hedging ratio went up from 57% to 67% (March-Sept).   Second, we think that an increasing share of Japan’s new capital exports will now run without FX hedges (as some life insurers indicated a month ago). Hence, it will be the volatility-adjusted return differentials moving increasingly into focus when Japan’s investors decide where to place bets. Here high-yielding currencies offer traction, helping to explain why high-yielding EM currencies have weathered the ‘USD storm’ remarkably well. Rising US real yield: Caution is warranted, nonetheless. A quick look at the 5y5y US inflation swap tells us why. Early December inflation expectations peaked near 2.55%,having falling to 2.37% since then and, while nominal yields have kept rising, real yields have jumped higher .For comparison,5y5y inflation expectations rose in the days after the Fed hiked rates in 2015, despite oil prices falling. Today’s decline of US inflation expectations has materialised despite the CRB Rind index trading near cycle highs, leaving the rising USD and the more hawkish Fed as the main reasons for this inflation expectation decline. Sure, EM economies are resilient compared to 2013 or last year when an equivalent rise in US real yields undermined the high-yielding EM asset class instantly. Higher US real yields tell us that EM risks have increased. AUD and KRW shorts: However, instead of shortinghigh yield EMFX, we are using this market as an indicator for how big the USD-low yield FX move will be. The longer the relative EM high yield resilience lasts, the higher USD will rise against low-yielding currencies such as EUR and JPY. Should – under the weight of rising real yields – EM wobble then we would reduce our low-yieldingFX short positions. We suggest selling KRW and AUD aggressively. Both currencies react adversely to falling risk appetite. Rising real rates have increased downside potential within risky markets such as shares. Most tactical share market indicators have reached frothy levels. Generally, we look into currencies from the bearish side where there are banks covering most of their liabilities via wholesale operations. Australia falls into this category. Its yield advantage to US Treasuries has declined to 27bp.