Why Do Foreign Central Banks Still Want U.S. Debt?

The latest report of major foreign holders of U.S. government debt was released on July 18, 2017, which reports the latest holdings at the end of May 2017.

Japan still holds the number one spot, but China is in a very close second.  From one year ago, both countries have decreased their holdings (China more than Japan), but it hasn’t been that significant.  The total holdings are also down, but again, not significantly.

Foreign central banks are mostly mercantilist, but this is especially true of the Chinese and Japanese central banks.  This means that they will buy U.S. Treasuries in order to hold down the value of their own currencies in order to boost their exporting sector.  The problem (for the people in those countries) is that it ignores the consumer.  It makes ordinary things more expensive for the people living in China and Japan.

The U.S. is not mercantilistic for the most part.  Donald Trump can be at times, but policies so far have not reflected his rhetoric.  Americans certainly have a lot to complain about in terms of the Federal Reserve and the U.S. government, but American consumers have nothing to complain about when it comes to being subsidized by foreigners.  As long as foreigners still love the U.S. dollar, Americans will continue to be subsidized.

Also, while the Fed has certainly been really bad for the last decade, it has engaged in a tight monetary policy for nearly three years now.  It has not expanded the monetary base since October 2014.  Meanwhile, the other major central banks of the world (Japan, China, Europe) all continue to inflate.  So even though the U.S. dollar should not be loved, it is easy to see why it is the most favored currency relative to all of the others.

You never know what will change in the future, but I certainly don’t see this mercantilistic view changing for the central banks of China and Japan any time soon.  If they decide to dump their U.S. Treasuries, it will be for other reasons.

It is easy to hear talk of China dumping U.S. Treasuries, but it hasn’t happened yet.  Maybe Chinese officials will allow some debt to mature without rolling it over, but it will not likely be significant.  The Chinese central bank will likely continue to accumulate more gold, but it will still be a small fraction compared to its holdings of U.S. debt and debt denominated in other currencies.

We have heard a lot of talk in the U.S. over the last few years about the Fed raising interest rates.  But if the Fed continues to raise its target rate and we get a recession, then long-term interest rates on U.S. bonds will likely go down.  American investors view U.S. government debt as safety, so that it where they will run to in difficult times.  Likewise, foreign central banks view U.S. government debt as a safe haven.

Therefore, until we see significant consumer price inflation, I do not think we are going to see significantly higher interest rates.  If anything, long-term rates will probably drop in the next recession.

If the Fed reacts aggressively (recklessly) in the next recession and expands its balance sheet further, then maybe we will finally start to see significant broad consumer price inflation.  Until that happens, you shouldn’t bet against the U.S. bond market.  Foreigners and U.S. investors still view it as a place of safety.

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