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Sept. 12 (Bloomberg) -- Japan is likely to replace China and U.S. banks as the lead supporter of Treasuries as the Federal Reserve moves toward ending bond buying, according to Bank of America Merrill Lynch.

Policy makers who next meet Sept. 16-17 have cut purchases of government debt and mortgage-backed securities to $25 billion a month from $85 billion starting last year. Buying by U.S. banks driven by rules limiting risk-taking and China more than offset the Fed’s tapering, keeping long-term interest rates low, said David Woo, head of global rates and currencies at Bank of America in New York. This is the Fed’s third round of purchases, or quantitative easing, to drive down borrowing costs.

“Effectively, there has been no tapering whatsoever so far,” Woo said at a round table in Tokyo on Sept. 8. “As the Fed was trying to unwind QE3, U.S. banks and China started a secret QE4.”

China held $1.27 trillion of U.S. notes and bonds at the end of June, compared with Japan’s $1.22 trillion, Treasury Department data show. Belgium more than doubled holdings in the past year to be the third-largest owner with $364 billion.

Belgium is home to Euroclear Bank SA, a provider of securities settlements for foreign lenders, and probably serves as a custodial holder for China, Woo said. He estimates the Asian nation increased purchases by about $130 billion in the first quarter, or $560 billion at an annual rate. China’s currency reserves rose to a record at the end of June.

“China in the first quarter was funding more than 100 percent of the U.S. budget deficit,” Woo said. “Between U.S. banks and China, they’ve been buying a boat-load of U.S. government bonds. This to me is the single biggest story of 2014,” he said.

BIS Regulations

Regulations set by the Bank for International Settlements in Basel, Switzerland, require institutions to hold more top- rated debt as a cushion against potential losses to ensure they can survive a crisis like the one that devastated the financial industry in 2008. The liquidity coverage ratio, stipulates the biggest U.S. banks must hold enough easy-to-sell assets such as cash and Treasuries to cover 30 days of stress.

“Bank buying of Treasuries is about to slow possibly by very much,” Woo said. “Global growth is probably going to be OK and that will also basically lend upward pressure for U.S. rates. High U.S. rates means U.S. fixed-income assets are going to become more attractive for foreign investors.”

Largest Fund

Japan’s Government Investment Pension Fund held 11 percent of its $1.2 trillion pool of retirement savings in overseas debt at the end of June, according to an earnings statement released last month. The world’s largest pension fund, which scheduled to announce its new investment strategy as soon as this month, will increase its target for foreign bonds to 14 percent, according to a Bloomberg News survey of analysts in May.

The GPIF will probably allocate about half of its holdings of overseas to the U.S., Woo said.

Japanese investors boosted their holdings of overseas bonds by 1.26 trillion yen ($11.8 billion) in August, Finance Ministry data show. Money managers purchased 449 billion yen of French sovereign debt in July and 1.1 trillion yen of U.S. securities, according to finance ministry data.

Treasuries will become more appealing to institutional investors, such as life insurers, when the 10-year yield climbs above 2.70 percent, Woo said. The yield has fallen about half a percentage point this year to 2.55 percent, according to Bloomberg Bond Trader data.

The dollar traded at 107.06 yen at 8:09 a.m. in Tokyo after appreciating to 107.20 yesterday, the strongest since September 2008. The U.S. currency will extend gains to 108 yen by year- end, according to Woo. The median estimate of analysts surveyed by Bloomberg is for 106 yen.

“I’m very bullish on the U.S. for the remainder of this year,” Woo said. “The U.S. recovery has a lot of momentum.”

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To contact the reporters on this story:
Mariko Ishikawa in Tokyo at mishikawa9@bloomberg.net;
Hiroko Komiya in Tokyo at hkomiya1@bloomberg.net
To contact the editors responsible for this story:
Garfield Reynolds at greynolds1@bloomberg.net
Pavel Alpeyev, Nicholas Reynolds

Bloomberg