American households are expected to hold a larger proportion of the U.S. Treasury’s debt issuance in the coming years. This could introduce cyclical volatility into the markets, according to a new analysis from MetLife Investment Management.
How should investors position their fixed income exposure, which is traditionally a more stable part of portfolios? VettaFi contributor Dan Mika spoke with MetLife IM macroeconomist and director Tani Fukui to learn more.
The following interview has been edited for clarity and brevity.
Dan Mika, VettaFi: Let’s start by walking through the slowdown in foreign exchange reserves and foreign central bank holdings of U.S. Treasurys that we’ve seen in recent years. Why does that lead to your and your colleagues’ conclusion that domestic actors will be taking on larger amounts of Treasury debt in the future?
Tani Fukui, MetLife IM: As a share of total domestic debt, we see a greater role for households simply because the share of foreign demand has declined. Globally, foreign demand has plateaued to a level basis, but that share of the total is now going to be more weighted toward domestic holders.
One major player is the household. Households won’t necessarily expand their levels; they tend to be very cyclical. Certain measures of volatility look much higher among households, but it’s really because they are very cyclical in their purchases. So when rates are high, like they are now, everybody is talking about buying Treasurys. When it’s lower, they don’t.
Then there are other domestic players, like insurance companies, for example, that are playing a larger role domestically.
VettaFi: Talk more about what that means if domestic households have more of a share. In your research, domestic households have much more volatility when they’re holding Treasurys between 1974 and 2023. What does that imply for how those types of investors are using bonds in their portfolios compared to foreign owners, investment funds, and institutional holders? And what does that mean for the future of how yields will work and how prices will work, if a larger share of the market is more cyclical and more responsive to market forces?
Fukui: That’s the real interesting question here. I think the fundamental point is that households themselves are not behaving massively differently than in previous times. They’re just taking on a bigger role because foreign demand looks like it’s declining. Historically, they tend to get into the market when rates are high, or when they’re worried about alternatives. They tend to stop purchasing Treasurys when there are interesting alternatives. … But if you do go back, let’s say, to the run-up to the financial crisis where everybody was buying houses, there’s a massive decline in households purchasing Treasurys. They basically exited Treasurys and entered the housing market, because that’s where the market seemed to be.
There’s just not as much of that stable foreign demand that acts as sort of the underwriter of U.S. debt. The U.S. Treasury market has really been historically reliant on a very, very stable, almost inelastic, consumer for many years, for decades. As those, let’s say foreign central banks, foreign holders, start to rethink their level of Treasurys holdings, you just don’t have that underpinning, that demand or purchaser that is basically innocuous, sort of impervious to changes in prices, whereas households are much, much more sensitive. Either they’ve lost their jobs and they have to liquidate their holdings just to survive, or they want to buy a house. Or rates are really low; therefore, they don’t see a point in having Treasurys. They’re very buffeted by other opportunity costs and their own personal circumstances.
VettaFi: The figure that I’m seeing here is that right now, domestic households only account for about 10% of holdings. Foreign holders are still the largest group. How much does that affect the potential volatility that might be occurring? There may be more cyclical household holders of Treasurys, but still a relatively small amount compared to a plateauing. But the majority of holders are still institutional and foreign holders.
Fukui: Yes, there is still this massive number and there’s a massive demand for Treasurys [from non-household holders], and it is still the majority. But the fact that you no longer have that bottomless, somewhat indiscriminate, purchaser means the marginal purchaser has a little bit more consideration for pricing, and what the yields, the total returns are going to be. That’s where it matters, even though we’re at above 30% for foreign holdings and 10% for households.
The volatility of the foreign holder historically has been so low that it makes the Fed practically trigger-happy, and they’re not exactly making changes to their policy too rapidly. The foreign volatility is much lower because those are also central banks that have a massive existing demand for having a certain amount of foreign exchange. If you’re trading with the U.S. or on the international markets, you need a certain amount of U.S. holdings.
But most countries have way more than that. They’re holding it for other reasons: strategy, safety, what have you. … They’ve been simply very indiscriminate, just taking all the Treasurys they can. Whereas all the other holders, households, the Fed — which is obviously a different story — and institutional holders, they are much more sensitive, much more discriminating, much more thoughtful about the relative rates of return.
Foreign official holders, for example, just wanted Treasurys. Now if you look at foreign official holdings, they’re just much more cautious about how much Treasurys they really need, and that’s really the concern here.
VettaFi: Suppose you are an investor, or a financial advisor with clients that are looking at a longer-term investment horizon, let’s say at least 10 years. What do you think that this research and these trends mean for those longer-term investors? What does this change, if anything, about how investors should think about where they deploy their fixed income portion of their portfolio?
Fukui: I can speak in general terms. As a good economist, I have to look at supply and demand. From a supply perspective, we recently clearly had this massive run-up in supply due to fiscal stimulus from the pandemic. We’re basically right around 100% Treasury debt to GDP ratio, which is historically high. And we’re not actively in any war at the moment. That’s an extremely unusual situation. That means there’s an enormous amount of supply available. All things being equal, you would raise yields, right? That’s historically already been the case. Barring other pandemics, other strange situations, we don’t expect a massive continued runoff. That’s a one-off, but certainly the debt levels themselves are high.
Then there are also questions of the willingness and ability of political parties to address the debt. Without getting political — which we don’t want to really get into — there’s not an enormous amount of discussion about balancing the budget. That’s not been a major topic of discussion this political cycle. So we are expecting the status quo of what the Congressional Budget Office is forecasting, then on the demand side.
We do see there’s [not necessarily a lot of overall decline]in demand in an alarming way, but there is this much more thoughtful approach by various types of investors. What kind should my Treasury exposure be? How much should it be? How should I look at Europe? Should I look at the yen, which is not generally a high yielding asset? Should I look at perhaps something like Canadian or Australian dollars, because those have improved in terms of their liquidity?
From a demand perspective, I don’t think it’s a massive change. I don’t think there’s a big decline in general demand. Certainly as yields are high, that makes it an equilibrium story there.
Based on those two things, it’s hard to see how we get back to the very low rates of prepandemic, and even back to sort of moderately low rates. … It’s hard to see how that goes further down without … short term crises, all sorts of situations, actual recession. You can see things deteriorate. But as a long-term equilibrium trend, it’s hard to see how that returns to anything close to the prepandemic level. … From a volatility perspective, this is not the type of volatility that we experienced in the stock markets [recently]. And when I refer to volatility, it really is over the business cycle. So it’s more applicable to a longer-term investor than a shorter-term investor.
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