Near zero U.S. Treasury yields

14 January 2009

Ousmène Mandeng, Ashmore Investment Management

The current global financial crisis brought short-dated U.S. treasury securities yields down to close to zero. Current U.S. Federal Reserve policy suggests that yields are going to stay low. This poses a dilemma for most investors but in particular for central banks that have remained disproportionately exposed to U.S. Treasury securities. As the financial crisis has undoubtedly shifted priorities from real returns to nominal capital preservation, most investors will be excused for not making money for some time. However, as near zero yields are not sustainable, more than ever, will investors have to consider to seek alternative investments.

Central banks are estimated to hold on average about 30 percent of foreign assets in bank deposits and the remainder in securities mostly denominated in U.S. dollars. Based on official holdings of U.S. securities, 57 percent of securities are treasury securities, 29 percent government agency securities, 10 percent equities and 4 percent corporate debt.1 Central banks tend to hold a large proportion of their securities in shorter-dated assets. The 2-year U.S. Treasury note can therefore be used as a proxy for reserve returns; it has reached its lowest yield for decades at 0.8 percent. Most central banks accumulate reserve assets on the basis of foreign exchange market interventions. Reserves therefore incur a funding cost that can be approximated by monetary policy stances (Chart). Central banks differ of course in the proportion of assets funded by interest-bearing instruments (instruments other than bills and coins); where this proportion is low, actual funding costs are low. Notwithstanding, the opportunity cost for the public sector as a whole of holding reserves and hence the fiscal return forgone, has increased significantly in particular with the rise in external debt service costs.

Pressure to adjust is greatest naturally where reserves are highest relative to immediate intervention needs. While the latter is difficult to establish with precision, the current crisis provides a good benchmark for actual reserve needs in times of distress. International reserve had declined on average by 15 percent for key emerging markets excluding China during August-November, 2008. The current global crisis has thus demonstrated that central banks hold far more reserves than needed to intervene and that there are more efficient alternative arrangements (e.g. U.S. Federal Reserve swap lines).

Central banks have traditionally not held foreign exchange reserves with a view to generate investment returns. Many central bankers will also insist that their prudent investments paid off by preserving capital when most asset classes have seen major losses. While this holds cyclically, the U.S. treasury 2-year note had an annual return corrected for annual average U.S. consumer price inflation of only 2.6 percent since 1980 and 0.6 percent since 2000. This does not seem enough to justify such prudence over the cycle. The current rate environment is therefore believed to bring forward considerations for broader reserve allocations as the risk of a significant value erosion of public assets is mounting.

Near zero yields are consistent with extreme risk aversion and/or deflation. With considerable certainty, yields cannot be assumed to stay at those levels for long as those factors eventually diminish. Portfolio diversification has therefore never been more appealing at least in nominal terms. Buying back debt also seems sensible. Either is likely to impact the investment environment considerably.

Central bank cost of carry

1 Data based on Department of the Treasury et al (2008), “Report on Foreign Portfolio Holdings of U.S. Securities”, Washington D.C.