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US to test investor appetite with deluge of long-term Treasury sales

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The US is set to flood the market with long-term bonds next year, raising questions over who will buy the debt and at what price.

The Treasury department plans to sharply shift its bond sales towards debt maturing well into the future as the government seeks to fund vast spending programmes.

Investors will be left to gobble up $1.8tn in Treasuries with maturities of greater than one year even after accounting for the Federal Reserve’s massive bond-buying programme, according to estimates by JPMorgan. This will mark a stark contrast to this year, when a far greater proportion of the Treasury’s issuance was in shorter-term debt.

With expectations for higher growth and inflation in 2021, strategists say the US may be forced to offer higher interest rates on these longer-dated securities to entice investors to purchase the debt.

“When we add the numbers up, we have a pretty big demand gap,” warns Jay Barry, a managing director on the interest rate strategy team at JPMorgan. “We think a modest rise in yields will be necessary to encourage demand.”

Treasuries serve as a key benchmark for other types of debt, meaning a rise in US government borrowing costs could cascade across the broader fixed-income landscape. Higher yields also represent one of the main risks for the equities market, analysts have said.

Column chart of Net issuance of long-term Treasuries excluding Fed purchases ($tn) showing US poised to flood market with debt

The deluge of long-term Treasury sales comes at a time when investors have already gravitated towards higher-yielding, riskier corners of financial markets in anticipation of a robust economic rebound next year and as the Fed continues taking actions to keep financial conditions loose.

US government bond prices have fallen, as a result, sending yields close to their highest levels in nine months. Longer-dated Treasuries have borne the brunt of the sell-off, with yields on the 10-year Treasury note climbing from below 0.7 per cent at the start of October to just under 1 per cent. 

The odds of a dramatic spike in borrowing costs is low, analysts and investors say. The Treasury has already funded the $900bn stimulus package signed into law by President Trump this week, according to Jefferies, and is currently sitting on a record cash pile of $1.5tn. Issuance of shorter-term debt, known as bills, is expected to decline next year as well, several fixed income strategists said.

But investors reckon the “supply overhang” in long-dated Treasuries — as Subadra Rajappa, head of US rates strategy at Société Générale, describes it — coupled with the spectre of resurgent growth and inflation will push Treasury prices even lower next year. Ms Rajappa forecasts 10-year yields will rise as high as 1.5 per cent.

Line chart of % of marketable Treasury debt showing Foreign holdings of US Treasuries has slid to a 20-year low

Expectations for higher yields stem in part from the Fed’s reluctance to expand its footprint in the market for US government debt.

Ahead of its most recent meeting on monetary policy, a cohort on Wall Street bankers and economists had called on the Fed to shift the bulk of its bond-buying programme to longer-dated Treasuries in order to ensure that financial conditions remain easy despite the enormous issuance slated for next year. It held off, leaving investors to mop up the additional supply. 

Foreign buyers are set to absorb some of it, despite playing a much smaller role in the market in recent years. At 35 per cent, their ownership of Treasury debt is at its lowest level in nearly 20 years, Fed data show. A chunk of the buying is likely to come from Japanese investors given that their domestic government debt holdings are guaranteed to make a loss if held to maturity, said Olivia Lima, a rates strategist at Bank of America.

Banks are also expected to follow up a record year of Treasury demand with another burst of buying. Mr Barry forecasts $200bn for 2021, with an additional $175bn coming from pension funds and insurance companies. That still leaves a $644bn shortfall, according to Mr Barry’s calculations based on overall Treasury issuance, even once other sources of demand are factored in.

Given this gap, Kathy Jones, chief fixed-income strategist at Charles Schwab, said the Treasury department will need to pay up to sell its long-dated debt. 

“The demand will be there,” she said. “It just depends on how it gets priced.”

Line chart of $tn showing Fed balance sheet booms as central bank looks to prop up economy

Two run-off elections in Georgia could further exacerbate the imbalance between Treasury supply and demand. If Democrats are able to win both races in January and clinch control of the Senate, more aggressive spending packages — and therefore heftier issuance — could be in the offing next year.

Goldman Sachs, which advocates for so-called “curve steepener” bets that profit if long-term yields rise faster than short-term ones, called the elections “the next major source of event risk for the rates market”. 

A move too far, too fast in long-dated Treasury yields that is driven more by supply and demand issues rather than the prospects of faster growth will not go unnoticed by the Fed.

The central bank may need to twist its bond buying towards longer-dated debt or even increase the scale of its bond-buying programme “if the markets start struggling to take down the supply in the first half of year”, said Blake Gwinn, head of short-term rates strategy at NatWest Markets.

That would put an end to any Treasury sell-off, added Oliver Brennan, a senior macro strategist at TS Lombard. “How the Fed decides to structure its demand is going to have the single biggest impact on the market.”



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US stocks rise as investors weigh strong earnings against spread of Delta variant

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Equities updates

Stocks on Wall Street edged higher on Tuesday as strong company earnings and economic data offset worries about the spread of the Delta coronavirus variant and fears over another regulatory clampdown from Beijing.

The blue-chip S&P 500 was up 0.7 per cent by mid-afternoon in New York, its best performance in more than a week. The tech-focused Nasdaq Composite climbed 0.3 per cent.

Investor sentiment was lifted by June data for US factory orders, which typically feed into estimates of gross domestic product. New orders for goods rose 1.5 per cent on the month before, well above the consensus estimate of 1 per cent.

In Europe, another wave of strong earnings results helped propel the continent’s stocks to a fresh record. The region-wide Stoxx 600 index rose 0.2 per cent after Paris-based bank Société Générale and London-listed lender Standard Chartered reported profits that beat analysts’ expectations.

London’s energy-leaning FTSE 100 index rose 0.4 per cent, aided by oil major BP, which rallied after announcing a $1.4bn share buyback programme and an increase in its dividend.

Line chart of Stoxx Europe 600 index showing Strong earnings help propel European shares to record high

On both sides of the Atlantic, earnings have been strong. More than halfway through the US reporting season, 86 per cent of companies have topped expectations on profits, while in Europe 55 per cent have outperformed so far, according to data from FactSet and Morgan Stanley.

“The continued healthy earnings outlook is a key driver of our view that the equity bull market remains on solid footing,” analysts at UBS Wealth Management wrote in a note. Such a growth rate is, however, “flattered by depressed levels in the year-ago period,” they said. “But the results are still impressive compared with pre-pandemic earnings.”

Oil slipped in a choppy session as the global benchmark Brent crude fell 0.7 per cent to $72.37 a barrel on fears that the spread of the Delta variant could depress demand for fuel.

The seven-day rolling average for new coronavirus cases in the US, the world’s largest economy, have hit nearly 85,000 from about 13,000 a month ago, according to the Financial Times coronavirus tracker. Similar trends have taken hold in other countries as well as authorities race to vaccinate larger swaths of their populations.

A log-scale line chart of seven-day rolling average of newcases showing that US coronavirus case counts rise from just over 10,000 in mid-June to nearly 100,000 by early August

In Asia, investors were again focused on regulation after Chinese state media criticised the online video gaming industry, calling it “spiritual opium”. Shares in Tencent, the Chinese internet group, fell 6 per cent before announcing it would implement new restrictions for minors on its gaming platform. NetEase and XD, two rivals, dropped 7.8 per cent and 8.1 per cent, respectively.

The Hang Seng Tech index, which includes Tencent and its peers, dropped 1.5 per cent, lagging behind the wider Hong Kong bourse, which slipped 0.2 per cent. The CSI 300 index of large Shanghai- and Shenzhen-listed stocks was flat.

Unhedged — Markets, finance and strong opinion

Robert Armstrong dissects the most important market trends and discusses how Wall Street’s best minds respond to them. Sign up here to get the newsletter sent straight to your inbox every weekday



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Why it might be good for China if foreign investors are wary

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Chinese economy updates

The writer is a finance professor at Peking University and a senior fellow at the Carnegie-Tsinghua Center for Global Policy

The chaos in Chinese stock markets last week was exacerbated by foreign investors selling Chinese shares, leaving Beijing’s regulators scrambling to regain their confidence while they tried to stabilise domestic markets. But if foreign funds become more cautious about investing in Chinese stocks, this may in fact be a good thing for China.

In the past two years, inflows into China have soared by more than $30bn a month. This is partly because of a $10bn-a-month increase in the country’s monthly trade surplus and a $20bn-a-month rise in financial inflows. The trend is expected to continue. Although Beijing has an excess of domestic savings, it has opened up its financial markets in recent years to unfettered foreign inflows. This is mainly to gain international prestige for those markets and to promote global use of the renminbi.

But there is a price for this prestige. As long as it refuses to reimpose capital controls — something that would undermine many years of gradual opening up — Beijing can only adjust to these inflows in three ways. Each brings its own cost that is magnified as foreign inflows increase.

One way is to allow rising foreign demand for the renminbi to push up its value. The problem, of course, is that this would undermine China’s export sector and would encourage further inflows, which would in turn push China’s huge trade surplus into deficit. If this happened, China would have to reduce the total amount of stuff it produces (and so reduce gross domestic product growth).

The second way is for China to intervene to stabilise the renminbi’s value. During the past four years China’s currency intervention has occurred not directly through the People’s Bank of China but indirectly through the state banks. They have accumulated more than $1tn of net foreign assets, mostly in the past two years.

Huge currency intervention, however, is incompatible with domestic monetary control because China must create the renminbi with which it purchases foreign currency. The consequence, as the PBoC has already warned several times this year, would be a too-rapid expansion of domestic credit and the worsening of domestic asset bubbles. 

Many readers will recognise that these are simply versions of the central bank trilemma: if China wants open capital markets, it must give up control either of the currency or of the domestic money supply. There is, however, a third way Beijing can react to these inflows, and that is by encouraging Chinese to invest more abroad, so that net inflows are reduced by higher outflows.

And this is exactly what the regulators have been trying to do. Since October of last year they have implemented a series of policies to encourage Chinese to invest more abroad, not just institutional investors and businesses but also households.

But even if these policies were successful (and so far they haven’t been), this would bring its own set of risks. In this case, foreign institutional investors bringing hot money into liquid Chinese securities are balanced by various Chinese entities investing abroad in a variety of assets for a range of purposes.

This would leave China with a classic developing-country problem: a mismatched international balance sheet. This raises the risk that foreign investors in China could suddenly exit at a time when Chinese investors are unwilling — or unable — to repatriate their foreign investments quickly enough. We’ve seen this many times before: a rickety financial system held together by the moral hazard of state support is forced to adjust to a surge in hot-money inflows, but cannot adjust quickly enough when these turn into outflows.

As long as Beijing wants to maintain open capital markets, it can only respond to inflows with some combination of the three: a disruptive appreciation in the currency, a too-rapid rise in domestic money and credit, or a risky international balance sheet. There are no other options.

That is why the current stock market turmoil may be a blessing in disguise. To the extent that it makes foreign investors more cautious about rushing into Chinese securities, it will reduce foreign hot-money inflows and so relieve pressure on the financial authorities to choose among these three bad options.

Until it substantially cleans up and transforms its financial system, in other words, China’s regulators should be more worried by too much foreign buying of its stocks and bonds than by too little.



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Square to acquire Afterpay for $29bn as ‘buy now, pay later’ booms

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Square Inc updates

Payments company Square has reached a deal to acquire Australian “buy now, pay later” provider Afterpay in a $29bn all-stock transaction that would be the largest takeover in Australian history.

Square, whose chief executive Jack Dorsey is also Twitter’s CEO, is offering Afterpay shareholders 0.375 shares of Square stock for every share they own — a 30 per cent premium based on the most recent closing prices for both companies.

Melbourne-based Afterpay allows retailers to offer customers the option of paying for products in four instalments without interest if the payments are made on time.

The deal’s size would exceed the record set by Unibail-Rodamco’s takeover of shopping centre group Westfield at an enterprise value of $24.7bn in 2017.

The transaction, which was announced in a joint statement from the companies on Monday, is expected to be completed in the first quarter of 2022.

Afterpay said its 16m users regard the service as a more responsible way to borrow than using a credit card. Merchants pay Afterpay a fixed fee, plus a percentage of each order.

The deal underscored the huge appetite for buy now, pay later providers, which have boomed during the coronavirus pandemic.

“Square and Afterpay have a shared purpose,” said Dorsey. “We built our business to make the financial system more fair, accessible, and inclusive, and Afterpay has built a trusted brand aligned with those principles.”

Adoption of buy now, pay later services had tripled by early this year compared with pre-pandemic volumes, according to data from Adobe Analytics, and were particularly popular with younger consumers.

Rivalling Afterpay is Sweden’s Klarna, which doubled its valuation in three months to $45.6bn, after receiving investment from SoftBank’s Vision Fund 2 in June. PayPal offers its own service, Pay in 4, while it was reported last month that Apple was looking to partner with Goldman Sachs to offer buy now, pay later facilities to Apple Pay users.

Steven Ng, a portfolio manager at Afterpay investor Ophir Asset Management, said the deal validated the buy, now pay later business model and could be the catalyst for mergers activity in the sector. “Given the tie-up with Square, it could kick off a round of consolidation with other payment providers where buy now, pay later becomes another payment method offered to their customers,” he said.

Over the past two years Afterpay has expanded rapidly in the US and Europe, which now account for more than three-quarters of its 16.3m active customers and a third of merchants on its platform. Afterpay said its services are used by more than 100,000 merchants across the US, Australia, Canada and New Zealand as well as in the UK, France, Italy and Spain, where it is known as Clearpay.

Square intends to offer the facility to its merchants and users of its Cash App, a fast money transfer service popular with small businesses and a competitor to PayPal’s Venmo.

“It’s an expensive purchase, but the buy now, pay later market is growing very rapidly and it makes a lot of sense for Square to have a solid stake in it,” said retail analyst Neil Saunders.

“For some, especially younger generations, buy now, pay later is a favoured form of credit. Afterpay has already had some success with its US expansion, but Square will be able to accelerate that by integrating it into its platforms and payment infrastructure — that’s probably one of the justifications for the relatively toppy price tag of the deal.”

Square handled $42.8bn in payments in the second quarter, with Cash App transactions making up about 10 per cent, according to figures released on Sunday. The company posted a $204m profit on revenues of $4.7bn.

Once the acquisition is completed, Afterpay shareholders will own about 18.5 per cent of Square, the companies said. The deal has been approved by both companies’ boards of directors but will also need to be backed by Afterpay shareholders.

As part of the deal, Square will establish a secondary listing on the Australian Securities Exchange to provide Afterpay shareholders with an option to receive Square shares listed on the New York Stock Exchange or the ASX. Square may elect to pay 1 per cent of the purchase price in cash.

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