Nov. 6, 2013
In my previous post about crude oil I touched upon a topic that generated additional interest from some of my friends in the Treasury markets. Specifically, I mentioned the potential impact of lower oil prices on “petrodollars” and the potential reduction in foreign demand for US Treasuries as a result.
Since global crude oil markets trade in U.S. dollar terms, it is common for net exporters to recycle their surplus dollar-denominated oil revenues back into U.S. Treasuries. Ten years ago, this phenomenon contributed to a “global savings glut” that helped push Treasury yields to record lows, and today, many economists, including Fed chairman Ben Bernanke, contend that this savings glut actually helped fuel the credit bubble that eventually led to the financial crisis of 2008.
Today, foreign holdings of Treasuries are about three times what they were in 2004, rendering the notion of a savings glut almost quaint. Much of this growth is related to rapidly rising foreign exchange reserves among BRIC and emerging Asian economies, attributable in large part to capital outflows arising from the Fed’s quantitative easing programs. As long as these capital outflows continue, foreign exchange reserve growth should follow, providing an ongoing source of foreign demand for Treasuries.
That said, the importance of petrodollars on the Treasury markets should not be underestimated. In fact, the large Middle East and North African oil exporters are such major players that the U.S. Treasury even has a category for “oil exporters” on its list of Major Foreign Holders of Treasury Securities. As of August, this group of nations represented the fifth largest aggregate holder of U.S. debt, just slightly behind Brazil and the Caribbean Banking Centers (representing large hedge fund and insurance company assets), but as recently as September of last year, they were the third largest holder, behind only China and Japan.
These petrodollars have been declining, however, as domestic oil production has risen, reducing the need for imports.
The trend towards energy independence is widely considered to be a good thing for the U.S. economy, and the shale boom has certainly contributed to domestic output in recent years, but if these trends continue, the amount of foreign petrodollars finding their way back into the Treasury market will likely decline. The issue will become even more pronounced if oil prices continue to fall.
This notion doesn’t readily translate into an actionable trade idea, as it is just one of many important variables in the demand equation for U.S. Treasuries, but it certainly should not be overlooked. All else being equal, rising domestic oil production, declining imports, and falling prices will reduce foreign demand for Treasuries while boosting output and providing much needed relief to consumers. Certainly something to keep an eye on in the weeks and months ahead.
