Debt sell-off stokes deflation fears

Fund Strategy - 23 Jan 2012 | By Gary Jackson

Despite demand for US treasuries remaining robust, countries such as China, Brazil and Russia recently cut their holdings in American government debt.

Although this does not yet represent a flight from treasuries, if it persists it could put pressure on domestic sources of credit or even threaten deflation over the longer term.

The Federal Reserve’s latest Treasury International Capital report shows net purchases of long-term treasuries by foreign official institutions amounted to $17.7 billion (£11.4 billion) in November, while private foreign investors increased their holdings by $40.3 billion.

But China continued to sell US treasuries over the month. The country’s holdings were $1.132 trillion in November, coming down from a peak of $1.173 trillion in July.

Frances Hudson, a global thematic strategist at Standard Life Investments, says China’s shrinking balance of payments surplus, appreciating currency and softening export growth are behind its lower treasuries holdings.

“The new buying has more or less completely dried up,” she says. “This is going to be a trend that will continue. There might be an occasional blip but you would expect this to persist in the long run.”

The reasons for other central banks scaling back their holdings reflect their own circumstances rather than a move away from American government debt, Hudson adds.

In the cases of Brazil and Russia, this can be attributed to shifts in commodity prices and the movement of goods around the world. With Switzerland, it is a result of the central bank’s recent intervention in the currency market.

Treasuries are likely to retain their haven status owing to a lack of alternatives in the debt market and the dollar’s position as the world’s reserve currency, Hudson says.

However, she adds that falling demand from foreign central banks will create greater pressure for domestic investors to buy more treasuries – especially if the Fed decides against launching a third bout of quantitative easing.

“If that happens, you might see weaker sources of credit for the rest of the US economy because if investors are buying treasuries they might not be buying corporate bonds. It could bring deflation back to the US as well,” Hudson warns.

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