Last week America’s Federal Reserve announced it would buy $600 billion (£375 billion) of American treasuries from financial institutions in a second round of quantitative easing (QE2).
Far from helping the American treasury market, however, could the Fed’s action help precipitate a crash?
The first round of QE already led to increased demand for American treasuries, increasing their price and decreasing the yield available to buyers.
The second round is due not only to push up prices and lower yields, but also to increase the supply of American dollars, potentially undermining their value and purchasing power.
As political willpower to cut the American deficit remains mixed, the treasury market also still suffers from massive supply and little sign of fiscal consolidation from the authorities. On November 5, 10-year treasuries yielded 2.5%, according to the Financial Times. This rate exceeds current American inflation, offering domestic investors a positive income in real terms.
But for emerging market investors, treasuries offer terrible value. QE2 looks set to force up emerging market currencies even further against the dollar, and 2.5% yields do nothing to compensate many emerging markets for inflation in their home countries. In China, inflation was already running at 3.6% in September. In India, it was as high as 9.8%.
This discrepancy would not necessarily be a serious concern were it not for the fact that emerging markets hold a gigantic proportion of the American treasury market. (article continues below)
According to the American treasury, America’s total public debt is $13.7 trillion (£8.4 trillion). Of that, the debt held by the public, as opposed to intragovernmental holdings, totals $9.1 trillion.
According to International Monetary Fund data, emerging market governments excluding China and Saudi Arabia hold $3 trillion in foreign exchange reserves and other assets. China says it holds $2.5 trillion. The Central Intelligence Agency (CIA) estimated Saudi Arabia held $410 billion at the end of 2009, but Jerome Booth, the head of research at Ashmore, puts this figure closer to $1.5 trillion.
Booth points out that as two thirds of foreign currency assets are held in dollars – typically American treasuries – emerging market governments control a vast proportion of the treasury market.
Extrapolating from the figures above, they could hold up to $4.3 trillion in treasuries, or half of the total not held by the American government. The statistic does not even take into account the American treasury holdings of private sector institutions.
For powerful emerging market investors it is not only the investment case that is disappearing fast. Booth says that emerging market governments have held American treasuries because they are highly liquid and can be sold if the authorities need to deploy them for any reason.
However, treasuries have become highly illiquid for emerging market governments as sudden sales on any scale could prompt a sell-off. Michael Power, a strategist at Investec Asset Management, says that QE2 also undermines the buying power of the dollar if emerging markets need to deploy their reserves, particularly to manage exchange rates.
The problem holds true even if financial institutions do not divert the QE2 money into emerging markets. In fact, Booth sees himself as an optimist, predicting financial institutions will put all the money into their excess reserves at the Fed to help recapitalise the banking system and encourage it to lend.
With or without QE2 money, strong growth should cause emerging market currencies to appreciate against the dollar and inflation to remain at average levels or higher, undermining the argument for treasuries. Following the mid-term elections, the political stasis in Washington also shows no signs of easing.
In the longer term, Booth says, emerging markets recognise the need to run more diversified reserve portfolios, but in the shorter term this adjustment may not be gradual. If inflation increases too rapidly, emerging market reserves can stop selling their currencies and buying dollar-based assets.
They may also need to sell dollar assets to invest directly in their economies and adjust to the consequences of an appreciating currency.
Selling dollar assets would increase emerging market currencies’ value and buying power and reduce the chance of inflation, but could create a vicious spiral for the dollar and for the treasury market. Power says dollar selling would be “a nightmare to coordinate”.
As QE2 worsens local tensions, Power warns, uncoordinated selling and a crash is “sadly much more likely”.