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One foot on the platform

July 21st, 2005

One of the questions that’s puzzled me for a long time is: who would be silly enough to buy US 10-year bonds? Given the massive trade deficit, it’s obvious that the US dollar will have to depreciate a great deal against all its trading partners to restore balance. Despite recent gains, it’s already a long way off its 2002 peak against the euro, and the problem was already apparent then.

The standard answer is that foreign central banks are buying US bonds to prop up the currency and keep their exports going. Reports from the US Treasury International Capital System give some support to this idea – foreign central bank holdings of US government securities have risen sharply. But when you look at the maturity structures reported in Tables 9a and 9b of the Report on Foreign Portfolio Holdings of U.S. Securities (PDF file) something interesting emerges. The median maturity for all holdings of long-term US securities is four years, but for official holdings its only three years. Nearly 75 per cent of all foreign holdings of US securities (and these amounted to $1.3 trillion as of June 2004) are for maturities of less than five years. For private holdings, the median is five years, and 25 per cent are for more than ten years.

This is very puzzling. It looks as if the foreign central banks are keeping their options open. At least if the dollar undergoes an orderly decline, they will be able to unload without too much loss. But private investors are in deep.

If this was equity investment it would be comprehensible – maybe these are people who really have faith in the capacity of the dynamic US economy to generate big profits. But large holdings of long term bonds seem almost impossible to rationalise

Over to you.

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  1. SJ
    July 21st, 2005 at 23:03 | #1

    But private investors are in deep.

    If this was equity investment it would be comprehensible – maybe these are people who really have faith in the capacity of the dynamic US economy to generate big profits. But large holdings of long term bonds seem almost impossible to rationalise.

    I’ll throw a few ideas up:

    - Naive duration matching. E.g. a defined benefit US retirement fund has payments due in ten years or so, and its charter, written twenty years ago, requires it not to “speculate” on stocks over that short a time, and also assumes a strongly positive yield curve, and so disallows large short-term holdings.

    - Agency. People put money into bond funds, (or balanced funds, etc. that have a bond component) and have no idea where the money ends up.

    - Hedge funds. There’s a shirtload of money gone into hedge funds since 2000. Where that money goes is anyone’s guess.

    - Perceived economic stability. Hey, the 5 year rate is x%, but the 10 year rate is x.1%, so that’s better.

  2. SJ
    July 21st, 2005 at 23:31 | #2

    But when you look at the maturity structures reported in Tables 9a and 9b of the Report on Foreign Portfolio Holdings of U.S. Securities (PDF file) something interesting emerges. The median maturity for all holdings of long-term US securities is four years, but for official holdings its only three years. Nearly 75 per cent of all foreign holdings of US securities (and these amounted to $1.3 trillion as of June 2004) are for maturities of less than five years. For private holdings, the median is five years, and 25 per cent are for more than ten years.

    Now that I’ve looked at the tables, John, I think you’re looking in the wrong place. Take a look at Table 9c. There’s a big lump in the 25-30 year maturity in foreign private holdings. This has nothing to do with 10 year bonds. The question is who bought the 30 year bonds in the last 5 years, and at what price? Did people jump out of stocks in 2000 into 30 year bonds? What was the coupon on the 30 year bonds at the time?

  3. Mr. Econotarian
    July 22nd, 2005 at 01:14 | #3

    While the US dollar may be in for some slight re-alignment over the long term, many places on the planet would be happy to have that kind of stability (or even have an opportunity for secure investments of any kind, for that matter).

    Besides, where else would you buy bonds, schlerotic Europe? China where there is great inflation and political risk? India which might vote itself back to socialism?

  4. jquiggin
    July 22nd, 2005 at 06:19 | #4

    SJ, the thirty year bonds are interesting, particularly as they haven’t been issued for some time, and most of the initial sales were (I think) domestic, but I still think the real action is in

  5. Katz
    July 22nd, 2005 at 15:57 | #5

    This is mere speculation, but is it possible that the trust deeds of certain pension funds require investment of a proportion of the fund in government paper? If so, this my help to explain apparently counter-productive investment decisions of private investors.

  6. stephen bartos
    July 22nd, 2005 at 16:16 | #6

    Katz has a point – not only defined benefit and 401 (k) deeds or terms may specify this, but there is also federal legislation (see http://www.dol.gov/dol/topic/retirement/fiduciaryresp.htm ) requiring the trustees to be prudent and diversify their investments which in the past has always been taken to mean a mix of stocks, bonds and real property.

    There are also other reasons for apparently irrational behaviour in this case, one good, one not so good, that could be hypothesised.

    The first is that bonds provide a certain, although lower, return – if there is a high premium placed on certainty by the investor they may take what appears to be an irrational decision. This may be the case for some of the plans, where there is a mandated requirement to provide information to beneficiaries about their future benefits and severe penalties for getting it wrong – in this circumstance, a rational administrator concerned both to save their own time and reduce their litigation risk might invest in bonds instead of shares. Especially so if said administrator gets paid the same whether the fund performs well or badly.

    The second is that US bonds are really well marketed. You can buy them online, there’s information about them pushed out to the marketplace every day, a strong selling effort is put in by the US Treasury. Whether or not you agree with the message, it is clear that marketing works: millions of people make sub-optimal investment decisions every day due to canny marketing by financial institutions.

  7. Razor
    July 22nd, 2005 at 16:48 | #7

    “maybe these are people who really have faith in the capacity of the dynamic US economy to generate big profits.”

    They’ve done it before and they’ll do it again. All the critics of Bush’s economic policy have been screaming about the twin deficits, the tax cuts etc etc and yet the economy continues to grow, increase tax revenues, increase jobs and create wealth.

    So much of the criticisms appear to be based on a pathological hatred of Bush-Republicans-Americans and not on what the economy is actually doing and able to do.

  8. jquiggin
    July 22nd, 2005 at 17:30 | #8

    Razor, reread the post. This would be a reason for investment in equity, not bonds.

  9. July 23rd, 2005 at 14:37 | #9

    Razor — once again your response seems to be based on a pathological love of Bush-Republicans-Americans (as though they are the same thing).

    In this instance, Q is not arguing that the economy is being mismanaged. He is asking a legit question about why individuals are going longer on bonds than the institutions that are holding up the bond market.

  10. Terje
    July 23rd, 2005 at 22:03 | #10

    QUOTE JQ: Given the massive trade deficit, it’s obvious that the US dollar will have to depreciate a great deal against all its trading partners to restore balance.

    RESPONSE: So long as the Federal Reserve owns a printing press and has collateral on hand it can make the US dollar worth whatever it wants. How typically Keynesian of JQ to recommend inflation as a solution to concerns about economic output.

    Private sector demand for US currency remains strong in part because as the most liquid currency in the world it is a defacto world currency. It is this strength that allows the Americans to run such a large trade deficit. It only becomes a problem if the world decides on some alternate defacto world currency. The Malaysian government has have been pushing gold as an alternative for a few years now.

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