Call it the Great Financial Mystery of 2014.
The small European country of Belgium this year suddenly became the world’s third-largest foreign holder of U.S. Treasury bonds — putting it behind only financial giants Japan and China.
The development has set Wall Street abuzz and inspired a raft of conspiracy theories among traders and analysts to explain what’s going on. Some say the Belgian buying spree is the work of worried European officials trying to prevent the Federal Reserve’s gradual tightening of interest rates from driving up rates in Europe. Others say it’s a subterranean effort by China to prop up the U.S. dollar and aid its ailing economy.
The mystery was spawned by a doubling of Treasury purchases emanating out of Brussels since August, which left the Belgian capital with an accumulated stash of Treasury bonds worth nearly $400 billion — more than double the amount it held through most of last year. The extra buying is equal to half of the country’s yearly GDP, or $20,000 for each of the country’s 11.1 million citizens.
The Brussels-based clearinghouse Euroclear has admitted that its clients — which include more than 90 countries and 2,000 financial institutions — were responsible for the purchases but would not say which clients were involved.
The cloak of anonymity provided by Euroclear set off whispers and speculation on Wall Street about why the surreptitious bond buyer or buyers are trying to avoid identification. Perhaps the most natural suspect that came to the fore was Beijing, which for years invested its massive $4 trillion foreign exchange surplus in Treasury bonds to drive up the value of the dollar and ensure Chinese exports remained cheap for its millions of American customers.
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“China is almost certainly disguising its Treasury purchases by holding them in Belgium,” said Benn Steil, analyst at the Council on Foreign Relations, who noted that China has bought U.S. bonds on the sly before through other offshore financial centers. By hiding its purchases, the Asian giant is trying to avoid setting off another firestorm of criticism on Capitol Hill that it was manipulating its currency, he said.
China’s practice of using its dollar earnings from the sale of exports to the United States to purchase Treasury bonds during the 2000s prompted widespread criticism from legislators and both the Bush and Obama administrations. They blamed China for using the technique to maintain a competitive edge in trade that led to lopsided trade surpluses with the U.S. Moreover, the bond hoarding was blamed for helping to create the credit bubble that caused the housing crisis and Great Recession of 2007-2009.
The outcry in the last decade forced officials in Beijing to pare back the practice for several years. China’s suspension of heavy bond buying since 2009, as expected, caused the dollar to fall and sparked a strengthening of the Chinese currency to record high levels, prompting even some of China’s fiercest critics to say last year that the trade and financial imbalances caused by China’s currency manipulation had come to an end.
But the change also helped cause a dramatic slowing in China’s economy, and this year, a portion of China’s currency gains suddenly disappeared as a result. China insists that it is not resorting to old tricks and trying to artificially gin up the dollar and exports to boost growth. But observers note that its exports and trade surplus are ballooning once again, and the Treasury Department this spring warned that it is watching closely to see if China is backtracking on its promise of reform.
Sifting the evidence
Mr. Steil said the evidence is compelling that China has resumed its purchases of Treasury securities to engineer a decline of more than 3 percent in the Chinese yuan against the dollar this year, a move that assists Chinese exporters in their battle to maintain market share in the U.S and other global markets. But because of the political pressure in the U.S., China felt it had to act in secret.
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“China’s central bank holds the key,” he said.
While China’s foreign exchange reserves are surging again, and because in the past the People’s Bank of China invested about 40 percent of those reserves in U.S. Treasurys, reports show that China’s official, publicly known holdings of Treasurys are in decline — something that just doesn’t add up, he said. The bank must be surreptitiously investing the surplus reserves through the Belgium clearinghouse, he said.
In one telling sign, China’s bond buying, as in the past, is having a substantial impact on U.S. financial markets, Mr. Steil said. He pointed out that the combined impact of Chinese and Belgian purchases of $59 billion of Treasurys in January alone was so massive that it could fully account for a mysterious decline in yields on 10-year Treasury bonds that month to 2.64 percent from 3.03 percent. The decline in interest rates was all the more puzzling because it came at the same time the Federal Reserve started to pare back its own massive purchases of Treasury bonds — a “tapering” that otherwise would have raised rates.
Beyond the unmistakable signs of Chinese intervention in financial markets, he said, “China’s actions would help explain why Belgium, a country whose [economy] is slightly smaller than that of New Jersey’s, has become the world’s third-largest holder of Treasurys,” he said.
But while some market gurus are confident that the culprit is China, there are alternative theories about the secret bond buyer that also would account for the enigmatic and unexpected drop in U.S. interest rates this year. Under one prominent theory, the culprit is Europe.
“One of the biggest questions at the end of 2013 was how the Treasury market would react to the reduction of bond buying that would result from the Federal Reserve’s tapering campaign,” said Peter Schiff, chief executive of Euro Pacific Capital. “Without the Fed’s bid, interest rates would have to rise.”
But six months into the campaign, with the Fed having cut its purchases by more than half, U.S. interest rates have actually fallen by a half point, he noted. It was that unexpected phenomenon that led Mr. Schiff to scrutinize the sudden and mysterious frenzy of bond buying from Belgium.
“The Belgian head-scratcher may be a simple case of central bank quid pro quo,” he said, noting that the Fed aided the European Central Bank in bailing out European banks during the European debt crisis, and now it looks like it may be getting a favor in return. Former Texas Republican Rep. Ron Paul, a monetary policy maven, also suspects a link between the two, he said.
“What is clear is that this is not likely the government of Belgium, or private Belgian capital, that is doing the buying. The numbers are just too large,” Mr. Schiff said. “The only European buyer with a wallet that big would be the European Central Bank.”
Mr. Schiff reckons that the European bank, which has openly discussed buying bonds to aid the ailing European economy, moved to purchase Treasury bonds just as the Fed was withdrawing from the market to ease the way for the Fed’s tightening and thus preventing a sudden uptick in interest rates, which would have roiled financial markets in the U.S. and Europe.
“Any panic in the bond market would cause yields to spike, which would have a strong negative effect on stock prices and economic confidence” — something both the U.S. and European central banks wanted to avoid, he said.
“It may not be coincidental that the Belgian buying began in earnest just as the tapering got underway. Something may in fact be rotten, and it’s not in Denmark but several hundred kilometers to the southwest,” he said.
A big part of the tantalizing mystery for investment experts is the dramatic effect the bond buying seems to be having on financial markets. Not only have U.S. interest rates stayed unexpectedly low despite the Fed’s tightening campaign, but the U.S. stock market has continued its bull run, with the Standard & Poor’s 500 index recently hitting another record high.
Investment analysts note that it is highly unusual to have such a strong rally in both stocks and bonds at the same time. The stock market traditionally rallies when the economy is doing well and growth is strong, while the bond market usually rallies when the economy is doing poorly and growth rates are falling.
Tom Porcelli, chief U.S. economist at RBC Capital Markets, has spent much of the year trying to solve the puzzle and has closely scrutinized the surge of Treasury bond buying by mysterious unknown parties.
“The question is, who is the big buyer?” he said. Market savants have postulated it could be anything from pension funds buying up long-term bonds to balance their portfolios to banks snapping up Treasurys to fulfill higher reserve requirements laid down by regulators. Some speculate that it’s not so much that institutions want to buy more bonds but that the Treasury has fewer bonds to sell as the federal budget deficit continues its dramatic decline, creating a shortage of supply, he said.
“And then there is Europe,” he mused, referring to theories that European bankers want to blunt the rise in interest rates being engineered by the Fed.
But Mr. Porcelli dismisses pretty much all such theories. His own pet answer is that traders themselves have caused the unusual surge in demand for Treasurys and the fall in interest rates through various maneuvers in response to the Fed’s change of direction this year. He expects interest rates to resume their historic pattern of rising later this year, when all the trader positioning and maneuvering has been “fully flushed out” of the market.