The Big Idea

Notes from Asia

Steven Abrahams | March 10, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The bid from Asia for US debt has long reflected the ups and downs of Asia trade and growth. And the bid for now seems to be on the upswing. Asia runs on trade, and most global trade still gets priced and settled in US dollars even outside of transactions involving the US. Demand for dollars rises and fall with foreign manufacturers’ need to import intermediate goods. And trade surplus raises demand for dollar investments. The cycle seemed in full swing last week in Hong Kong and Korea, with prospects for faster growth in China hovering around all the conversations with investors.

In Hong Kong, banks flush with dollar deposits have started taking a new look at the relatively high yields on US Treasury debt and MBS. Funding with trade-sensitive deposits makes liquidity and preservation of principal critical. And these portfolios need alternatives to a limited market in US dollar corporate debt issued by Chinese companies. Appetite for US corporate and structured credit seems low. Conversations last week revolved around concerns familiar to any investor in Treasury debt and MBS: the terminal fed funds rate, the shape of the US yield curve, spreads in MBS and relative value.

In the background, there seems to be fragile optimism that China’s global trade will grow and lift the supply of investable US dollars sitting in Hong Kong. The International Monetary Fund in January estimated China’s reopening will lift real GDP from 3.0% last year to 5.2% this year—a sharp contrast with declining projected growth in most other countries. Hong Kong houses the investment arms of both large mainland banks and local banks. And both types of banks seem to be getting ready for larger dollar portfolios. But the optimism is tempered by trade tensions with the US, which could disrupt trading flows and dollar deposits across Asia.

In Korea, investors seem worried that trade tensions between China and the US could leave Korea out the China rebound. Korea has surfed the boom in China’s global trade for 20 years by selling intermediate goods to China’s manufacturers. But last year, Korea’s trade surplus with China almost vanished, dropping from $23.7 billion US dollars in 2021 to $1.2 billion in 2022—the lowest surplus this century. And continuing trade tensions could keep Korea’s exports to China on ice.

The interests of Korea’s US dollar investors consequently seem less about investing dollar deposits and more about using dollar debt markets as sources of profitable trades or for the depth and diversity of dollar markets. Portfolios looking for carry in dollar investments have to bear the cost of hedging from dollars into Korean won, which is running around 2% a year. A few pockets of Korean investors are looking at speculative grade CLOs or similar instruments that can still deliver significant net income after hedging costs. Other portfolios have challenges similar to Korea’s National Pension Service, which has a portfolio that has grown too large for Korea’s domestic debt markets. These portfolios in recent years have increased their allocation to global fixed income, including a healthy exposure across a wide range of public and private US fixed income.

Despite some interest in the more esoteric and less liquid parts of US debt markets, Asia’s portfolios remain dominated by US Treasury debt and agency MBS. The latest Treasury survey published February 28 and tallying balances through June last year shows portfolios in Japan, China, Taiwan, Hong Kong, Singapore and Korea dominated by Treasury debt and agency MBS (Exhibit 1). Those countries could have stakes in the large corporate holdings held in custody in financial centers such as the UK, Luxembourg, Cayman, Ireland, Switzerland or Bermuda. But the pattern identified by Bernanke and others still likely holds, where Asia prefers government and agency obligations and Europe prefers credit.

Exhibit 1: The 25 largest foreign holders of US debt

Note: *Countries with large custodial holdings. Data reflect only long-term debt.
Source: Treasury International Capital System, Santander US Capital Markets

The other twist to Asia flows, at least compared to those that first brought Asia’s portfolios to US markets 20 years ago, is that the strongest interest now comes from private portfolios rather than official government ones. That showed on the meeting schedule last week. And it seems to show up, too, in the monthly figures from the Treasury International Capital System, although the Treasury does not break out government from private flows by product in each region. But globally through 2022, for example, foreign government portfolios reduced Treasury note and bond portfolios by $173 billion while private portfolios added $931 billion (Exhibit 2). Both government and private portfolios added agency debt and MBS exposure, government portfolios by $162 billion and private portfolios by $141 billion. And government portfolios added $17 billion in corporate exposure while private portfolios have added $148 billion. Government portfolios added a net $5 billion in exposure to long-term US debt with private portfolios added $1.2 trillion.

Exhibit 2: Foreign government buying of US debt has broadly lagged private

Note: $Million. Data shows long-term debt only. Corporate bonds include ABS.
Source: Treasury International Capital System, Santander US Capital Markets

The private bid for US debt in Asia and globally disperses investment across a much wider set of portfolios interested more in the returns available from the assets rather than the value in managing currency or other policy goals. Private managers in Asia seem to be pushing the trend. And a rebound across Asia this year could give those managers the resources to make a difference in US markets.

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The view in rates

Market reaction to the failure of SVB Financial has repriced a wide set of risks. OIS forward rates a week ago had projected fed funds approaching 5.50% by August, but the market closed Friday with OIS projecting only 5.30%. The market is probably overgeneralizing SVB’s issues. The bank had specialized in serving the venture economy, and a year of low investment in venture companies and steady cash burn had depleted SVB’s deposit base and triggered this week’s rout. It is possible that other banks may take SVB’s experience as a cautionary tale and raise balance sheet liquidity and reduce risk. That could do some of the Fed’s job for it by tightening credit. Time will tell. The bigger issue for the Fed remains persistent inflation, and the Fed is likely still on a path to rates in the mid-5.0%s.

Fed RRP balances closed in the last few days at $2.19 trillion, nearly unchanged from a week ago. Despite apparent Fed expectations that attractive rates in money markets will draw funds away from the RRP, it clearly is not happening yet.

Settings on 3-month LIBOR have closed Friday at 514 bp, up 15 bp on the week. Setting on 3-month term SOFR closed Friday at 512 bp, up 18 bp on the week. The spread between these benchmarks is now as narrow as it has been in at least five years.

Further out the curve, the 2-year note closed Friday at 4.59%. The 10-year note closed at 3.68%

The Treasury yield curve has finished its most recent session with 2s10s at -90 bp after hitting -108 bp on March 8. The 5s30s finished the most recent session at -26 bp after hitting -46 bp.

Breakeven 10-year inflation finished the week at 228 bp, down 19 bp in the last week. The 10-year real rate finished the week at 140 bp, down 14 bp in the last week.

The view in spreads

Volatility has jumped higher on rising rates and the SVB news. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields closed Friday at 161 bp, up 3 bp on the week. Par 30-year MBS TOAS has closed Friday at 51 bp, tighter by 2 bp on the week.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market are funded with floating debt. Leveraged and middle market balance sheets are vulnerable, especially with the sharp tightening of bank credit. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. Some commercial real estate funded with floating-rate mortgages have started to show some stress, too.