Tracking foreign central bank (FCB) holdings of US Treasury and Agency (Fannie, Freddie, and minor government agencies) paper has been one of the most important lines of inquiry in my analysis of market liquidity for the past 9 years. This information is available virtually in real time each week in the Fed’s weekly H41 report. It tells us just how much the FCBs have been subsidizing the US financial markets.
Their purchases of government paper were not only crucial to funding the US government’s spending week in and week out, but to the pricing of the bond market as a whole, and to the US financial markets generally. By typically absorbing the equivalent of 25% of the new Treasury issuance week in and week out for years, the FCBs provided a huge subsidy for the US financial markets, pushing Treasury yields down to artificially low levels, removing competitive pricing pressures for other assets, and pumping excess liquidity into the US system. That action artificially pushed up the prices, not just of Treasuries, but of all assets, especially equities and, for a while, housing prices.
All that began to change a little more than a year ago when FCBs began to gradually reduce their rate of purchases. The change was so subtle that the markets hardly noticed. But the Fed noticed, and it was forced to step in with two rounds of quantitative easing (QE), or money printing, to help absorb the Treasury supply and make up for the reduction in FCB purchases of Treasuries and Agencies. With reduced FCB subsidies, the Fed had no choice. Had it not stepped in, both the Treasury market and the stock market might have collapsed. As it happened, the European meltdown provided a new subsidy source for Treasury paper, as capital flight from Europe boosted the Treasury market, so that the absence of the FCBs again was not missed.
Then about 7 weeks ago, the FCBs not only slowed their purchase rate of Treasuries and Agencies, they began selling outright, and have continued to do so at unprecedented levels. This is a whole new ballgame, where, instead of helping to absorb new supply, the FCBs are actually adding to that supply by dumping their own holdings into the market. This would present a crisis for the US market which the Fed would be forced to address were it not for the renewed meltdown in Europe, and now the situation with the collapse of MoFo Global. Once again, the Treasury market gets the benefit of the buildup of fear. The panic is leading to massive buying of Treasuries. The fact that the FCBs are absent hasn’t been noticed.
But the underlying problem of the FCBs no longer subsidizing the US market remains, and once the panic into Treasuries subsides, the pus filled boil of the Treasury market will explode onto the mirror of the world market. Without FCB support, the US Treasury and equities market will both be in big trouble at some point in the not too distant future. Here’s the chart along with a brief comment that I wrote about it in this week’s Fed report update. This chart remains an ominous indicator.
The FCBs were sellers again last week, which is bearish. The FCB indicator, based on a 4 week average, is still rising, but from an extremely weak level. While the direction is still bullish in the short run, the overall level is still bearish, with both intermediate and longer term bearish implications. Without a strong recovery, the next downturn in this indicator will have strongly bearish implications. Can Only Have One, Not The Other
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