The dollar’s reserve-currency status
Currency analysts love to invoke Churchill’s famous 1947 remark about democracy when discussing the greenback’s reserve status, that it’s the worst reserve currency, except all the others.
The US dollar accounts for 61.9% of the world’s known foreign exchange reserves, according to the IMF, equivalent to $3.7 trillion at the end of Q2 2013. While the dollar’s share is about 1% lower than it was the same time last year, and 10% lower than it was a decade ago, it remains the dominant reserve currency of the world’s central banks.
While the euro has steadily increased its reserve holdings since it was introduced in 2002, eurozone break-up fears are still relatively fresh in the memory.
China’s ambition for the renminbi to become a reserve currency, meanwhile, will require at least a decade of economic and financial reform to be taken seriously.
Treasury market liquidity
With $11.3 trillion in outstandings at the end of the first quarter, the Treasury market accounts for nearly 30% of the total size of the US bond market, which at $38.7 trillion is more than twice the size of the next largest, Japan.
As this summer’s emerging markets crisis revealed, foreign exchange reserve managers require markets that are large and liquid enough to accommodate central bank buy and sell orders on demand.
According to Federal Reserve data, certain central banks sold a record $32 billion of US Treasury holdings in June to generate liquidity to finance currency market interventions after the US said it would start tapering down its quantitative easing (QE) programme.
Political risk not credit risk
Despite Capitol Hill’s continued willingness to bandy about the threat of technical default, and the loss of its triple-A credit rating, markets simply do not view US sovereign default as a credible scenario.
“It’s important to distinguish between credit risk in a market like Greece and the chance that the US government may incur some technical inability to make interest payments in a timely manner,” says one market source. “There is a big difference between a complete balance-sheet restructuring and a political situation that delays payment. It’s simply not the same risk at all.”
Indeed, reports that US fixed NAV money-market fund managers sold holdings of Treasury bills maturing on or around October 17 over fears that the government would fail to redeem its obligations missed the point, says James Bianco, president of Bianco Research in Chicago.
“The repositioning in T-bills was technical,” he says. “Fixed NAV money-market funds have to price at a NAV of $1 at the end of each day. With no legal opinion to tell these managers how to price the T-bill if the government delayed repayment, they were forced to sell.
“It’s important to note that government bond funds were buying all the T-bills that money-market funds were selling. The resulting spike in yield was 50 basis points and any suggestion that money markets were selling on fears of default is grotesquely overstated.”
The credibility of Federal Reserve monetary policy
Although it’s unclear what the consequences of a fifth year of QE will be in the long-run, the market on the whole still believes the Fed is doing all it can to fulfil its dual mandate of promoting economic growth while keeping inflation below 2%.
Indeed, the nomination of Janet Yellen, a policy dove who once discussed the possibility of keeping QE in place until 2015, suggests the Fed will continue to err on the side of caution in the tapering debate while inflation seems contained.
“The Fed has gone to extraordinary lengths to maintain its dual mandate, and the appointment of Yellen indicates we will see monetary accommodation continue while inflation remains well anchored,” says one market source.
And so long as there is QE, there will extraordinary support for the Treasury market.
Regulations driving demand for high-quality assets
The new regulatory paradigm will increase demand for US treasuries both as a source of liquidity and as collateral to secure OTC derivatives transactions.
Basel III’s liquidity coverage ratio, mandatory central clearing for OTC derivatives and forthcoming money-market reforms will all support long-term demand for the high-quality liquid assets, ie US treasuries.
Indeed, concerns about the future availability of US treasuries and other government bonds prompted a Bank for International Settlements investigation into asset encumbrance to build a clearer picture of how much collateral will be needed for regulatory compliance and how much will be free to trade.