The Big Idea

Foreign demand for US debt looks increasingly sensitive to yield

Steven Abrahams | May 31, 2024

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. This material does not constitute research.

The rising share of US debt held by foreign private portfolios instead of foreign central banks seems to be changing overall foreign demand. In the shifting aggregate foreign allocation to Treasury debt or credit or agency MBS, there are signs that relative yield—or, more broadly, relative value—is making a bigger difference. The typical foreign buyer is no longer a central bank focused mainly on liquidity but more often a foreign commercial bank or insurer focused on net interest income, liquidity and a wider menu of considerations. That has made foreign demand for US debt much more dynamic.

Over the last decade, foreign central banks and other official portfolios have lowered their share of US debt while private portfolios have gained. In mid-2014, for example, foreign central banks and other foreign official portfolios held 68% of Treasury debt held outside the US but today hold only 47%. Central banks and official portfolios have also trimmed share in agency MBS and played only a very minor role in credit. Central banks typically invest foreign currency reserves in Treasury debt in part for yield but much more for the liquidity needed to defend their currency if need be. But private foreign buyers are much more likely to focus on earning net interest income, making the yield on the US dollar investment extremely important.

Over much of the last decade, the level of Treasury yields has increasingly influenced foreign portfolio allocations to Treasury debt. With 10-year yields below 3% and often below 2.5% from mid-2014 through late 2020, for example, the share of the aggregate foreign portfolio in US Treasury debt slipped steadily (Exhibit 1). Foreign investors, reported by the Fed as holdings by the rest of the world outside the US, trimmed Treasury holdings from more than 58% of debt held to nearly 51% (Exhibit 1). As 10-year yields then climbed from late 2020 into early 2022 from 0.50% to 3.0%, Treasury share rebounded. Holdings rose from 51% of debt to 56% of debt. Through 2023, yields rose to 4.0% and above, but Treasury allocation has slipped.

Exhibit 1: US Treasury yields have influenced foreign allocation to Treasury debt

Source: Federal Reserve Enhanced Financial Accounts, Santander US Capital Markets

Although the level of Treasury yields seems to influence foreign investor allocation, so, too, does yield in competing assets. As Treasury allocation dropped from mid-2014 through late 2020, the allocation to corporate and structured credit picked up (Exhibit 2). Treasury allocation dropped from 58% to 51%, but credit allocation rose from 32% to 39%, entirely absorbing the share lost by Treasuries. As Treasury allocation then rebounded from late 2020 into early 2022, going from 51% to 56%, credit share dropped from 39% to 34%. As Treasury share then dropped by roughly 1% in recent years, the share in agency obligations—largely MBS but including agency debt—has gone up slightly less than 1%. Foreign portfolios clearly will trade out of Treasury debt if the yield in risk assets is sufficient. This looks like a hallmark of private demand.

Exhibit 2: Shifting foreign allocation to Treasuries, credit and agency debt, MBS

Source: Federal Reserve Enhanced Financial Accounts, Santander US Capital Markets

The apparent sensitivity of foreign buyers to yields in Treasury and other debt likely reflects the waning influence of foreign central banks and the rising influence of commercial banks, insurers, hedge funds and other private portfolios. This creates a much more dynamic source of demand for US debt.

For most of the last few decades, central bank demand heavily reflected the rise and fall of currency reserves. Now foreign demand is much more likely to reflect dollar deposits at foreign commercial banks or dollar insurance liabilities or hedge funds trading relative value. This distributes investor demand among a wider set of portfolios than just the central bank in countries with a trade surplus. The relative value trading that has long shaped US fixed income debt portfolios seems likely to get increasing traction in foreign portfolios as well.

* * *

The view in rates

Fed funds futures for a fifth week price roughly 34 bp of easing this year as of the Friday close. The market-implied probability of cut45 at different meetings also are roughly unchanged. The market sees a 5% chance of September and a 56% chance of December. It’s still all about sticky inflation. In the aftermath of the last FOMC, implied rate volatility continues to trend lower, although recently bouncing off the lows of the year.

Other key market levels:

Fed RRP balances closed Friday at $440 billion, down $9 billion in the last two weeks. RRP balances have bounced between $400 billion and $500 billion since the start of March. That range has held despite yields on most Treasury bills running well above the RRP’s 5.30% rate.
Setting on 3-month term SOFR closed Friday at 534 bp, up 1 bp in the last two weeks.
Further out the curve, the 2-year note closed Friday near 4.87%, up 5 bp in the last two weeks. The 10-year note closed at 4.50%, up 8 bp in the last two weeks
The Treasury yield curve closed Friday afternoon with 2s10s at -37, steeper by 3 bp in the last two weeks. The 5s30s closed Friday at 14 bp, also steeper by 3 bp over the same period.
Breakeven 10-year inflation traded Friday at 236 bp, up 3 bp in the last two weeks. The 10-year real rate finished the week at 215 bp, up 5 bp in the last two weeks.

The view in spreads

A trend to lower volatility should create more room for spreads in all risk assets to tighten a little further. Credit still has the most momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risk and riskless.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 85 bp, tighter by 2 bp in the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 143 bp, wider by 3 bp in the last two weeks. Par 30-year MBS TOAS closed Friday at 39 bp, wider by 4 bp in the last two weeks. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp in OAS, although the number may be lower with credit spreads so tight. Nevertheless, widening in MBS toward fair value looks reasonable.

The view in credit

Higher interest rate should raise concerns about the credit quality of the most leveraged corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress, with most metrics renormalizing back to late 2019 levels. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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