The four years before the crash of 2008 were boom times. Easy money, higher commodity prices and thriving global trade propelled economies. In 2007, more than 100 countries expanded faster than 5 per cent, which was about five times the norm post World War II.
Such vibrancy stoked inflationary pressures. While inflation rates stayed tame-ish, bond investors expected yield to rise, which they did. Over these years, US 10-year Treasury yields climbed from as low as 3.7 per cent in March 2004 to as high as 5.3 per cent in June 2007. But yields didn’t always rise to expected heights and often fell unexpectedly. Many bond investors of that era were bewildered by yield movements that clashed with healthy readings on economies and inklings of inflation.
The key to the puzzle was Chinese buying. After the Asia crisis of 1997-98, countries in the region amassed foreign-exchange reserves, to better protect their economies and currencies come another crisis. No country gathered more forex reserves and US Treasuries than China.
CEIC data shows China’s forex reserves hit a record high US$4.0 trillion (then about $4.5 trillion) in 2014, while its holdings of US Treasuries peaked at US$1.3 trillion in 2012. The data shows China’s forex reserves surged sixfold from US$250 billion in 2003 to US$1.5 trillion in 2007, roughly the same pace as its purchases of US Treasuries over those years. Such frantic buying was unheard of at the time, which was why bond investors were blindsided.
This lesson is relevant because something akin to the reverse might be underway today. That phenomenon is the attempt by US foes to escape the reach of Washington’s financial sanctions. To do that, they must ‘dedollarise’. In practice, that means they must own fewer US-dollar-denominated assets.
Sanctions to disrupt adversaries
The US has long used sanctions to disrupt the economies of adversaries. The Embargo Act of 1807 entailed actions against France and the UK for harassing US ships. In the 1960s, many sanctions were directed at Cuba. During Barack Obama’s first term as president, Washington slapped an average of 500 entities a year with sanctions for everything from human-rights abuses to violating territorial sovereignty, according to a Foreign Affairs count. That number doubled during the presidency of Donald Trump. Joe Biden is not shy about sanctions either. At the end of December, the US Treasury’s Office of Foreign Assets Control had 38 ‘active sanctions programs’ in place. These programs target countries, companies and individuals.
Washington can employ financial coercion against foes because the US dollar is the world’s dominant reserve currency. At some point, US-dollar transactions handled by foreign banks fall under US jurisdiction as these banks must hold accounts at the Federal Reserve. The most controversial US sanctions are ‘secondary sanctions’ – where third countries must comply with US policies to maintain access to the US financial system. Controversial, too, is the decision to freeze half of Russia’s forex reserves after it invaded Ukraine in 2022. This directive against Moscow shattered the belief that Washington wouldn’t touch such stashes for fear such a step would undermine faith in the US-led financial system.
Unsurprisingly, US rivals have decided they must detach themselves from the greenback’s dominance. But perhaps to some astonishment, many US allies and neutrals have come to the same conclusion. China and Russia are creating the clearing-house and financial-messaging infrastructure for trading and investing in their currencies. China is using its diplomatic power to internationalise the yuan (when it’s used by third parties) and promotes an e-yuan for the same purpose. The People’s Bank of China is offering swap lines to allow other central banks to exchange their currencies for yuan.
Many countries are now conducting transactions in currencies other than the US dollar. Countries such as India, for instance, are trading with Russia in non-US currencies. China and Saudi Arabia have signed a currency swap worth US$7 billion, as countries in the Middle East look to shift non-oil trade away from the US dollar. The United Arab Emirates has accepted payment in yuan. And so on.
It will, however, take a mighty, decades-long effort to topple ‘King Dollar’ because the currency holds a status no primary reserve currency has ever held. The efforts of the anti-US bloc might fail. But global rivalries nevertheless demand US foes dedollarise and reduce holdings of US Treasuries.
Outflows from US Treasuries
The extent to which this is happening might surprise. In September 2023, US Treasuries suffered their first outflows since 2021 when a net US$1.7 billion fled as China and Japan trimmed their hoards. Bloomberg calculates that over the three months ended September, foreign demand for US government bonds was at its lowest since the three months to May 2020.
The Wall Street Journal reports that foreign private investors and central banks nowadays own only about 30 per cent of US Treasuries compared with about 43 per cent a decade ago. China and Japan were assessed to have reduced their US Treasury holds by US$182 billion over that time.
Bond investors no doubt understand that dedollarisation means more upward pressure on the world’s most consequential bond yields. Harder to factor into US Treasury yields is the risk that a US dollar weakened by dedollarisation could break the US-led global financial system. Dedollarisation is not a benign shift.
Other forces, to be sure, are bound to pressure bond yields more than dedollarisation. US adversaries have other reasons besides dedollarisation to ditch Treasuries: China was recently selling US bonds to support the yuan. The Japanese are apparently rebuying Treasuries now that Japan’s economy is stuttering. Maybe affection will break out between the China-led and US-led blocs and everyone will happily hold US dollars again.
Greater tensions are more likely. Bond investors always need to allow for political factors when evaluating where bond yields might head. At least, they hold this advantage over their predecessors of the mid-2000s: the actions of China and other US foes are no mystery.