When Foreign Central Banks Diversify

In aggregate, this hasn't happened yet. Indirect bidding for the Treasury bonds most liked by indirect bidders (many of whom are foreign central banks) has not slackened. The favored bonds include TIPS and nominal two- and five-year notes. An exception to this are the nominal 10-year notes, which have seen a little weakness in indirect bidding. But in aggregate, given the increasing financing needs of the U.S. Treasury, demand for Treasury securities is still strong.

What is stronger still is foreign demand for U.S. dollar agency bonds and corporate bonds. There are more net foreign purchases of agencies and corporates combined than Treasuries, and the rate of growth is faster at present. It almost looks like the foreigners are hungry for yield in U.S. dollars.

What are the costs of diversifying out of U.S. dollar debt for a foreign central bank? Carry and political favor. Central banks do not need to earn a lot of money, because usually the only beneficiary is the government, so giving up "carry" (interest earnings) is often a minor issue. Political favor is a bigger issue. Central banks are often influenced by politicians, who are in turn often influenced by exporting industrialists who support them politically. The exporters disproportionately benefit from a weak currency vs. the dollar, and would encourage the central bank to buy dollars and hold them in order to strengthen the dollar.

Where this fails is if holding the dollar induces inflation into the economy of the exporter. After all, from the point of view of the nation of the exporter, goods are going out, and promises to pay (bonds) denominated in a foreign currency come back. The bond holdings lead to an expansion of the central bank's balance sheet, which can lead to an expansion of credit. If there aren't enough goods to buy at existing prices given the increase in purchasing power, inflation can result. To some degree, this inflation is occurring in creditor nations of the U.S., but it is showing up in real estate, rather than goods prices. (This excludes Japanese residential real estate. I don't know if the Bank of Japan has enough inflationary gasoline to ignite that soggy log.)

As a result, my main conclusions are that any diversification out of the dollar by central banks will be:

Led by smaller central banks, such as Singapore, Russia, or India.

Led by central banks with greater political independence, such as New Zealand.

Led by central banks with large dollar reserves relative to U.S. exports, such as Taiwan (though Taiwan won't do it for political reasons).

All of this implies that it will be a slow process, because the larger central banks holding U.S. debt obligations are less independent and are large exporters to the U.S. So, pressure on the currency and bond markets from direct selling (or not buying) of U.S. dollar-denominated debt by foreign central banks should be gradual in nature. The effects that arise from other market players that attempt to front-run the foreign central banks could be a larger concern. Other players in the U.S. dollar debt markets are more flexible and panicky than the foreign central banks; when news breaks of actual diversification, such as was mentioned by Marc Chandler, selling can swamp the market, even if just temporarily.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

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