By Jamie McGeever
ORLANDO, Fla. (Reuters) – An apparent rundown of global foreign exchange reserves this year is just a mirage related to U.S. dollar strength – but the real thing may yet materialize and pack another punch for the ailing U.S. bond market.
The narrative around a reserves rundown has gained traction but doesn’t bear closer scrutiny. Reserve managers, overall, have been net buyers of Treasuries this year, for example.
It is true that an increasing number of central banks are intervening in the currency market to sell dollars, and the nominal value of their FX reserves and U.S. Treasury holdings has declined.
But the aggregate fall has been mostly driven by valuation effects. In the case of Treasuries, it has been entirely due to plummeting prices.
The latest available Treasury International Capital (TIC) data show that the nominal value of overseas official holdings of Treasuries stood at $3.709 trillion in July, down from $3.913 trillion last December.
That nominal fall of $204 billion is on course to be the biggest annual decline since 2016, and second-largest ever.
But research by Fed economists Carol Bertaut and Ruth Judson, who help compile and present the TIC data, is instructive. Their models published earlier this year estimate monthly flows net of valuation effects.
Their analysis shows that valuation effects account for a near-$270 billion decline in total holdings this year, and that central banks actually purchased almost $65 billion of U.S. Treasuries in the first seven months of this year.
They were net buyers in five months, and sellers in April and May.
“Official holdings are falling, but not because central banks are selling. So far this year, it has been down to valuation effects,” said Frank Warnock, professor at the University of Virginia and senior research advisor to the Fed.
“But we don’t know what’s going to happen in the coming months,” he added.
INTERVENTION TENSION
Central banks across Asia and Latin America, most notably the Bank of Japan, have recently intervened directly in the FX market selling dollars for local currency. This may have involved selling U.S. Treasuries.
But Bertaut and Judson’s calculations call into question some of the more frenzied market chatter in recent weeks that the soar-away dollar could force central banks to bump U.S. bonds for FX intervention purposes.
They are as accurate an interpretation as any of the ebb and flow of central bank demand for Treasuries. The estimated $270 billion valuation change reflects a 7% fall from end-2021 holdings, which is broadly in line with the 7.5% slide in Bank of America’s aggregate U.S. Treasuries index over the period.
Central banks bought into that downturn but it is unclear whether that continued through August and September, when the BofA Treasuries index lost another 6% and central banks’ FX intervention picked up pace.
Partial custodial data from the New York Fed suggests there was net selling in August and September.
The fear is that FX intervention involves selling Treasuries, opening up a potentially serious ‘doom loop’: yields rise, making the dollar more attractive, pushing the dollar higher, forcing central banks to intervene again and in greater size.
We’re not at that stage yet, however.
“Only a handful of countries appear to be actually intervening in the foreign exchange market by selling Treasuries,” says Marc Chandler, head of FX strategy at Bannockburn Global and a veteran FX reserves watcher.
Until the next few TIC reports are released – August data is out on Oct. 18 – we can only speculate. China and Japan, the world’s biggest holders of FX reserves, have released September reserves data but neither give a breakdown of currency or asset composition.
The nominal value of China’s FX reserves stood at $3.029 trillion in September, the lowest since March 2017. Since July, the last month of official TIC data, they dipped $75 billion, or 2.4%.
Japan’s reserves fell to $1.238 trillion in September, also the lowest in five and a half years. They were down some $85 billion, or 6.4%, since July. In nominal terms.
It must be noted, however, that the dollar’s broad value rose 6% over those two months, while the BofA Treasuries index fell 6%. These are two powerful valuation shifts that could distort the figures in a big way.
Steve Barrow, head of G10 strategy at Standard Bank in London, warns that official sector sales of Treasuries could ultimately necessitate counter action from the Fed and others.
“There is a growing danger that dollar strength and substantial currency intervention will serve to make global monetary conditions too tight,” he wrote on Monday.
(The opinions expressed here are those of the author, a columnist for Reuters.)
Related columns:
In reverse currency war, there’s only one winner (Sept. 23)
Dazed and confused enough to buy bonds (Sept. 21)
RIP Great Moderation, hello Great Volatility (Aug. 30)
(By Jamie McGeever; Editing by Andrea Ricci)
