Intensifying financial stress and increased volatility have shaken global markets and stimulated a move of capital into the safety of the American dollar.
With the Fed continuing to raise interest rates, expect the flight to safety to continue.
Whether it is the purchase of short-term Treasury notes, the depositing of cash in U.S. financial institutions or a greater use of the Federal Reserve’s overnight reverse repurchase facility, investors and foreign banks are in a flight to safety
Spurring these moves are the growing interest rate differentials that have helped fuel the dollar’s rise and are roiling global financial markets.
The trend is likely to continue. With the Fed continuing to raise interest rates, expect the purchases of Treasury securities to remain solid, foreign deposits in American banks to increase and the Fed’s reverse repurchase facility to swell toward $3 trillion.
Already in September, foreign purchases of U.S. Treasury notes neared $2.5 trillion, according to Fed data.
With U.S. bond yields pushing past 4%, international investors can borrow at near-zero costs and earn higher nominal returns on U.S. assets augmented by the currency return of a soaring dollar. This is especially the case for Japanese investors, whose domestic bond yields are stuck at near zero.
At the same time, foreign banks are parking their cash in their U.S. branches, according to flow of funds data maintained by the Federal Reserve. Rather than risk a freeze in domestic financial markets, foreign banks have in effect taken out an insurance policy by keeping those funds liquid as a backup.
Finally, the demand for the safety of Treasury securities is most apparent in the front end of the yield curve, where returns are relatively immune from a bond market selloff and have reached 3% for overnight rates.
The Fed’s repo operations were put in place in the wake of the financial crisis to provide liquidity at the front of the curve. Treasury securities parked there are used as collateral for shorting the bond market. Today, that market has become an important tool for the trading community.
The demand for short-term securities should moderate the impact of the Fed’s rate hike, but exacerbate the bond market selloff further out the yield curve.
