Wednesday, November 19, 2008

Japan tackles hot topic - Tbonds denominated in foreign currencies

Yesterday, we got the Treasury International Capital (TIC) flow numbers which underscores an interesting development in recent weeks and months. In all this upheaval of the financial crisis all asset classes declined except the USD and US short and long dated government bonds, which actually increased in value. Brad Setser in his excellent blog for the Council on Foreign Relations (CFR) breaks down the numbers and concludes that "foreign demand for any US bond with a smidgen of credit risk has disappeared".

"Normally, this kind of fall-off in foreign demand would be associated not just with a credit crisis but also with a currency crisis. ....The US, though, isn’t a normal country. The fall in demand for risky US assets was offset by a rise in demand for Treasuries and the sale of foreign assets by Americans."

To illustrate the point click to enlarge the chart

Granted Treasuries are perceived as risk free, yet even Setser admits that "holders of long term Treasuries are clearly holding a lot of currency risk". In this context Yves Smith from the excellent blog "naked Capitalism" picks up an interesting piece of news coming form Japan.

Japanese economists are increasingly concerned with the ability of the United States to finance its enormous deficits. Credit default swaps on the benchmark 10-year contracts on Treasuries have risen to 42 basis points from below two basis points at the start of the credit crisis in July 2007. While Setser still calls this an Armageddon trade foreign officials are not taking it in stride.

Many believe that the dollar looked strong in recent weeks for technical reasons. Money that US financial firms had invested abroad are being repatriated which caused a demand for dollars. Once this subsides there could be a run on the currency. Even if this is exaggerating the situation and we only see a substantial devaluation of the USD, foreign officials will not like to see their Treasury holdings decline in value. This is why economists in Tokyo are now calling for the new administration "to issue US Treasuries denominated in yen and other currencies".

The inevitable consequence of a lack of trust in US financial assets could be that Japan, China and other emerging market central banks will eventually reduce their holdings of US Treasuries. The so called sovereign wealth funds (SWFs) contributing to global capital flows is also increasingly unlikely since those countries will have to fight their own demons on their own turf. The only way to reduce foreign currency risk for the financiers of the US current account imbalances seems to come from US Treasury bonds denominated in foreign currencies. This will not change until the US and global economy are on a clear trajectory to recovery which might not occur for another year or two...and even then it is far from certain that investors will again bestow their trust in US financial leadership.

Yves Smith also delves into the interesting issue of motivation for Japan to tackle this hot topic, after all the author writes, "if America's good buddy and military protectorate is making noises about foreign currency Treasuries, it is hard to dismiss the idea out of hand".

source: You know it is a crisis when the trade deficit could have been financed just by selling t-bills to China and European banks
CFR, by bsetser, posted on Tuesday, November 18th, 2008

source: Japanese Float Idea of the Treasury Selling Yen-Denominated Debt

naked capitalism, Wednesday, November 19, 2008

original news source: Japan economists call for 'Obama bonds'

By Kosuke Takahashi, Asia Times

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