China Overblown Treasury Risk, but Europe, Japan and US Fed Pose Larger Risks

The recent rise in U.S. interest rates was enough that some of the bull market’s biggest cheerleaders started to get at least a little nervous. It turns out that the rumors that China was going to stop or seriously slow down its buying of Treasuries isn’t true. That being said, there are still other risks to weigh for interest rates. Among those risks are the Federal Reserve, Bank of Japan and European Central Bank.

A rapid rise in interest rates was seen this week on reports that China was ready to take action in U.S. Treasury notes and bonds. Bloomberg reported on Wednesday that Chinese officials reviewing the country’s vast foreign exchange holdings were recommending a halt or a slowing of U.S. debt purchases.

According to the Treasury Department’s data as of October, China was the largest foreign holder of U.S. government debt at $1.19 trillion held. China’s own total foreign exchange reserve balance was listed as $3.14 trillion in December.

Now Xinhua has reported that the State Administration of Foreign Exchange issued a statement that the report was inaccurate, and the “fake news” term has been widely used in media reports now.

While the thought of a $1 trillion holder of debt backing away sounds scary, the reality is that the market can absorb this if it is not liquidated in short order. The Federal Reserve itself is on track to wind down its massive $4.5 trillion balance sheet. That vast portfolio may be cut in half (perhaps by $2 trillion or more), but the timing is expected to be gradual, spread out over the coming years, with many caveats and outs if they need to take a breather.

It is widely expected that Fed Chair Jerome Powell will not rock the boat by unloading the Fed’s massive balance sheet too fast and in a disorderly way. He also is not expected to overly raise interest rates in a “too far and too fast” manner. That being said, Credit Suisse just raised its rate hike expectations for 2018 on Thursday. The new view is that Powell will raise federal funds three times rather than the prior view of two rate hikes, taking the target fed funds range up to 2.00% to 2.25%.

What may pose a larger risk than China holding so much U.S. Treasury debt is if the European Central Bank (ECB) changes its guidance to investors sooner than expected regarding the eurozone’s stronger economic recovery. Dow Jones reported that the minutes of the bank’s December meeting signaled that officials widely agreed that the ECB would need to gradually change its guidance to investors about its future policy actions. That would be to de-emphasize the importance of quantitative easing and that the slower bond buying could be phased out even ahead of inflation reaching the 2% target.

Elsewhere, the Bank of Japan was recently reported to be tweaking its bond purchases. This has generated at least some speculation that the bank is looking to slow down the pace of its own easing efforts.

If you want just a little more fuel added to the bonfire of interest rates, Bill Gross has now issued to fortune-teller call that the great bear market in bonds has officially started. Gross, also known as the Bond King, has now suggested that there are several reasons that the 10-year Treasury yield should get to 2.70% by the end of this year. Frankly, that is not a very high yield considering that it just challenged 2.6% already. It is also far short of the forecasts of 24/7 Wall St. — we can see the 10-year yield challenging 3.00% again in 2018, before challenging the late 2013 highs when the yield reached 3%.

There are many risks when it comes to how Treasury yields can rise. But there are a dozen or more issues that could derive higher Treasury yields in the long and intermediate part of the yield curve. Still, at some point, high rates cure high rates because they can start to look more attractive than the dividend yields offered by the Dow or S&P 500 Index.