Friday 9 September 2022

Foreign Treasury holdings, QT and the Euro bounce

The chart below shows that a UK/ EU or Japanese financial can buy US Treasuries (2yr here) and XCCY asset swap them back to local Libor and lose money vs RFR, 20-35bps in Europe and 70bps in Japan. Or they can hold local assets, which in the case of the UK and EZ now have a positive and rising yield given rate hikes coming, and have no counterparty capital charge. 

For example, UK 2yr Gilt yields about 3% right now where as SONIA -25bps yields about 1.45%. 3m Gilt about 2.4% yield.


There are a couple of charts below from the Treasury report that is produced annually. You can see foreign holdings, which are dominated by European/ UK/ Japanese investors rose by Trillions as ZIRP/ QE policies were implemented after 2008. Since pre-Covid foreign holdings of Treasuries have increased from circa $4Tn to almost $8Tn. These flows along with equity flows have covered the US current account deficit since 2008.


But this is now a negative carry/ unattractive trade for the previous buyers. 

So there are a few implications, as foreign financial buyers reduce/ disappear and in some cases sell existing holdings, at the same time as the Fed is unwinding its balance sheet, either domestic buyers come in, or yields rise.

Both scenarios are negative for US asset prices as it either increases the discount rate or increases the discount rate and causes US domestic portfolio rotation away from risky assets and into Treasuries.

So this is the portfolio channelling, with a leverage factor, of QT into US asset markets is happening in coming months. Its also broadly USD negative, and along with the fading energy narrative I think may have put a floor under the Euro and Sterling this week. When the BoJ starts to hike rates the effect will be amplified, but Yen likely to remain weak until then.  

Going forwards capital will have a cost and govt bond issuance risks crowing out other borrowers.

It will also affect private markets. If LBOs have been financed at 5.5x senior debt/ EBITDA and Lev loans pay about L+5.5%, then with the Fed hiking to 4% the leveraged loans will yield 9.5%, which at 5.5 debt/ EBITDA is going to use up over half the EBITDA for interest service. EBITDA margins are also going to fall as credit slows and the economy slows and in a recession, EBITDA will fall a lot. So there are going to be a few zombie LBOs out there.

I think this is quite important from an asset allocation standpoint over the next six months.

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