What would happen to the financial markets if Japan or China intervened in the foreign exchange market, selling off the US dollar, supporting their own currency, and in the process, sold off US Treasury bonds? Even a decade ago, this scenario was hard to imagine.
However, now such a scenario seems possible as China and Japan, the two largest holders of US debt, are reducing their holdings. Data show that the holding levels of US Treasury bonds by China and Japan in the world's largest and most liquid government bond market have dropped to their lowest levels on record, or at least the lowest since data comparable from the 1990s.
As of June, the total size of US Treasury bonds held by China and Japan was $2 trillion, accounting for 7.8% of the $25 trillion in US Treasuries available for trading, well below the record 25.4% held by the two countries in June 2007.
The latest data show that the Federal Reserve holds $5 trillion of US Treasury bonds, accounting for 20% of the entire market. China's holdings amount to $835 billion, about 3.4% of the total market, the lowest level in over 20 years; Japan's holdings are $1.11 trillion, about 4.4% of the total market, also reaching a historical low.
Despite China and Japan reducing their holdings of US Treasuries, they remain the world's two largest holders of US debt. If one includes US Treasuries held by state-owned banks, wealth funds, and those suspected to be held through third-party countries like Belgium and the UK, China and Japan's holdings of US Treasuries might be even more significant. The simultaneous reduction of US Treasury holdings by China and Japan has not impacted other bond investors, global markets, or policy makers in Washington.
In the first decade of this century, Japan, oil-producing countries, and emerging market nations, especially China, converted massive trade surpluses into US Treasuries, thereby building up substantial foreign exchange reserves. Brad Setser, a senior fellow at the Council of Foreign Relations, stated that no single country could dominate the bond market, as investors in the US Treasury market come from governments, sovereign funds, and large financial institutions around the world.
Adjusted data show that in the first half of the year, China's holdings of US Treasuries decreased by $34 billion after valuation adjustments, while Japan's holdings increased by $40 billion. However, China's holdings of US agency debt increased by nearly $20 billion.
In June, foreign central banks' total holdings of US Treasuries increased by $26.5 billion to $3.54 trillion, with nearly $100 billion added in the first half of the year. This increase of $100 billion is related to the Federal Reserve's reduction of holdings and an increase in the issuance volume of Treasury bonds. Currently, the Federal Reserve continues to reduce its holdings at a rate of $60 billion per month, while the issuance of Treasury bonds is also surging.
As US Treasury yields reach their highest levels since the turn of the century, the increasingly wide yield gap pushes the exchange rates of the yuan and the yen to historic lows. The real effective exchange rate (REER) of the yen is near its 50-year low, and the REER of the yuan is close to its 10-year low.
As the depreciation trend of the yuan and yen continues, more people speculate that China and Japan are providing funds for interventions in the foreign exchange market by reducing their holdings of US Treasuries. A strategist from Bank of America said last week that although there is no evidence yet that China and Japan are reducing their bond holdings to prepare for currency intervention, the possibility of the two countries obtaining intervention funds by selling off US debts increases as the US dollar strengthens and the yuan and yen exchange rates continue to fall.
