KEY TAKEAWAYS

• Foreign buying of U.S. bonds has slowed over recent years but remains a firm source of demand in the domestic bond market.
• Foreign purchases are likely to continue to take a backseat to economic growth and Federal Reserve interest rate expectations as a driver of bond prices and yields.

FOREIGN FACTORS

Gauging foreign demand for U.S. bonds, Treasuries in particular, is a constant source of attention for bond investors, with foreign ownership of outstanding U.S. Treasuries remaining fairly constant at approximately 50% over the past few years. The yield disparity between foreign and domestic government bonds remains near historically wide levels and continues to influence the bond market [Figure 1]. However, foreign buying interest alone does not account for price movements among high-quality bonds.

STILL BUYING

Last week’s release of Treasury International Capital (TIC) system data for February showed a decline in foreign purchases of U.S. Treasuries. Japan swapped places again with China as the largest foreign holder of U.S. Treasuries, but few additional insights emerged. The TIC data are significantly delayed and subject to sizable revisions, limiting their usefulness as a gauge of foreign bond buying.

However, other data show foreign buying remains steady. A look at more timely data from the Federal Reserve Bank of New York shows that foreign buying decelerated from late February through most of March 2015, only to pick up again in late March through the start of April [Figure 2]. Bond prices increased in March and decreased at the start of April, almost exactly the opposite direction that foreign buying would indicate, which suggests more dominant forces are at work.

Classic drivers of bond prices and yields-economic growth and Federal Reserve (Fed) expectations-arose once again to dominate price action in the bond market, despite the presence of increased foreign buying. Specifically:

• Weaker economic growth. Disappointing economic results from February 2015 through early March revealed that economic growth was likely to slow from the sluggish 2.2% pace of the fourth quarter of 2014. Current forecasts for first quarter 2015 economic growth stand at 1.4%, according to Bloomberg. Weaker growth lowers the risk of Fed rate hikes and suppresses the odds that inflation breaks free of its stubbornly low range.
• Reduced Fed rate hike expectations. At the conclusion of its March 2015 meeting, the Fed announced significant reductions to projected overnight borrowing rates, suggesting a later start and slower pace of interest rate hikes. Bond prices rose and yields fell through the end of March in response.

Last week’s weaker than expected monthly retail sales report reiterated the impact of economic data. Retail sales fell short of expectations and consumer spending remains lackluster to start 2015, despite savings from lower energy prices. The consumer spending data led to a reversal of a weak start to the second quarter of 2015 for the bond market.

Details of recent Treasury auction results show a gradual increase in foreign demand for new Treasuries, offset by weaker domestic demand. The percentage of auctions awarded to “indirect bidders”–a group of investors who submit bids for auctions via the New York Fed, a majority of which are foreign central banks and monetary authorities–has gradually increased over the last several months [Figure 3]. Even the 30-year Treasury bond auction, a security that historically has not witnessed much foreign demand, has seen a modest increase in the amount awarded to indirect bidders since the middle of 2014.

Click here for Figure 3, Foreign Buying Interest at Treasury Auctions Has Increased, While Domestic Demand Has Softened.

At the same time, demand from domestic investors has waned as low yields have reduced demand. The percentage of recent auctions awarded to “direct bidders”–a group of investors that bids directly through the Treasury rather than through a bond dealer–has gradually decreased in recent months [Figure 3] to less than 10% across the auction maturities shown, down from 10-20% for most of 2014. Although foreign demand remains firm, it has been offset by weaker domestic demand.

CHANGING MIX

Overall, the pace of foreign buying has slowed in recent years but remains a steady and firm presence in the bond market. Foreign institutions, such as central banks, have slowed their purchases, and weaker economic growth abroad has reduced excess reserves that are typically invested into Treasuries. But as institutions have reduced their involvement, others have taken up the slack to keep foreign interest in the U.S. bond market elevated. Additionally, TIC data reveal demand for other sectors, such as corporate bonds, has strengthened, while Treasury purchases have slowed.

Still, charting total foreign holdings of Treasuries shows that while the pace of buying has slowed, it nonetheless remains on pace with overall growth of the outstanding Treasury market [Figure 4].

Foreign domiciled investors remain a source of support for the U.S. bonds as recent data attest to. Nonetheless, classic drivers of bond prices and yields–economic growth and Fed rate expectations–will continue to potentially have a greater impact on the direction of bond yields.