Sovereign reserves and the USD

Many market observers have noted that holdings of US Government bonds by Sovereign Reserves Managers (Central Banks and Sovereign Wealth Funds) has declined in recent years whereas the USD remains well bid.  These commentators view this as contradictory and that the long term implication of lower Treasury bond holdings should be a weaker dollar.

This is incorrect.  I am very proud to say that I wrote a paper together with Min C. Lie (1) almost 20 years ago that argued for separate bond and hedging benchmarks for Sovereign investors.  At that time, if a Sovereign held 40% of their assets in US Treasuries they also held 40% of their assets in USD.  This is inefficient.  Min Lie and I argued that the Sovereign could reduce their holdings of US Treasuries in a dollar-neutral way by using currency forward contracts to buy exposure to dollars.  This broke the link between the portion of debt in a portfolio and the currency.

My suspicion is that Sovereign investors are reducing their holdings of US Treasuries while hedging their currency risk back to USD.  This leaves the USD unaffected in the trade (selling USD is offset by buying USD forward) whereas other reserve assets are purchased in place of the bonds eg. Chinese bonds or Emerging market debt. The easiest way to express a benchmark is to nominate fully-hedged, partially-hedged or unhedged to base currency.  Again, my suspicion is that the Sovereign investors are adopting a fully hedged benchmark.

Another observation is that Sovereign investors are continuing to divest their US Treasury holdings quarter over quarter.  This slow switch is taking place as they reinvest their coupon receipts into other bond markets.  With coupons on Sovereign debt relatively low the process of moving to a new benchmark could take years.  Expect the decline in US Treasury holdings by Sovereign investors to continue for many years.

(1) The paper is Fisher and Lie (2004)”Asset allocation for Central Banks: Optimally combining liquidity, duration, currency and non-government risk” in Risk Management for Central Bank Foreign Reserves Bernadell et al Eds. European Central Bank press