China and Japan Sell, Hedge Funds Buy: Has the U.S. Treasury “Risk-Free, Low-Return” Formula Broken Down?

Weaker demand from major holder countries raises concerns about expanding U.S. Treasury supply
Higher yields attract capital seeking interest income and trading gains
Private investors account for a growing share of the U.S. Treasury buyer base

China and Japan, major players in the U.S. Treasury market, have been reducing their holdings. China is diversifying the investment destinations for its foreign exchange reserves, while Japan may have sold Treasuries to secure dollars needed to defend the yen. Losses from falling Treasury prices and concerns over increased supply stemming from deteriorating U.S. public finances are also dampening sentiment toward long-term bonds. As concerns about expanding Treasury supply grow, hedge funds are playing a larger role in the market. With major holder countries cutting their positions, private capital seeking interest income and trading gains is accounting for a growing share of the Treasury market.

China’s U.S. Treasury Holdings Hit an 18-Year Low

According to the U.S. Treasury Department’s Treasury International Capital (TIC) data released on the 19th (all dates hereafter are local time), China held USD 590.7 billion (approximately USD 609 billion) in U.S. Treasuries at the end of August, down USD 27.3 billion (approximately USD 28.2 billion) from the previous month. The 4.4% monthly decline brought its holdings to their lowest level in 18 years, since August 2008. Holdings fell from USD 659.3 billion (approximately USD 680 billion) in May this year to USD 633.4 billion (approximately USD 653 billion) in June and USD 618 billion (approximately USD 637 billion) in July, before declining again in August. The three-month reduction totaled USD 68.6 billion (approximately USD 70.7 billion), equivalent to 10.4% of holdings at the end of May. In particular, the monthly decline widened from USD 15.4 billion (approximately USD 15.9 billion) in July to USD 27.3 billion (approximately USD 28.2 billion) in August, indicating that the pace of reductions had accelerated again.

The longer-term trend also shows a steady decline in China’s U.S. Treasury investments. Holdings fell by USD 109 billion (approximately USD 112 billion), or 15.6%, over the year from USD 699.7 billion (approximately USD 722 billion) last August. Compared with USD 684.4 billion (approximately USD 706 billion) at the end of last year, holdings have declined by USD 93.7 billion (approximately USD 96.6 billion) this year. China’s share of total foreign holdings of U.S. Treasuries also fell from approximately 7.6% last August to 6.3% this August. China’s holdings peaked in November 2013 at more than USD 1.3 trillion (approximately USD 1.34e+3 billion). Over roughly 13 years since then, its holdings have fallen to less than half that level. China is currently the third-largest holder of U.S. Treasuries, behind Japan and the United Kingdom.

Japan, the Largest Holder, Also Dumps USD 35.6 Billion

Japan, the largest foreign holder of U.S. Treasuries, has also been reducing its holdings. At the end of August, Japan held USD 1.0683 trillion (approximately USD 1.10e+3 billion), down USD 35.6 billion (approximately USD 36.7 billion) from a month earlier. The monthly decline was approximately 3.2%. Japan’s holdings declined for four consecutive months, from USD 1.2099 trillion (approximately USD 1.25e+3 billion) in April this year to USD 1.1431 trillion (approximately USD 1.18e+3 billion) in May, USD 1.1167 trillion (approximately USD 1.15e+3 billion) in June and USD 1.1039 trillion (approximately USD 1.14e+3 billion) in July. The total decline over this period was USD 141.6 billion (approximately USD 146 billion), equivalent to 11.7% of holdings at the end of April. Monthly declines narrowed from USD 66.8 billion (approximately USD 68.9 billion) in May to USD 26.4 billion (approximately USD 27.2 billion) in June and USD 12.8 billion (approximately USD 13.2 billion) in July, before widening again in August.

Japan’s holdings have surrendered their gains from early this year and fallen below last year’s level. They rose from USD 1.1855 trillion (approximately USD 1.22e+3 billion) at the end of last year to USD 1.2393 trillion (approximately USD 1.28e+3 billion) in February, but by the end of August were USD 117.2 billion (approximately USD 121 billion) below the previous year-end level. The reduction over the subsequent six months was more than three times the USD 53.8 billion (approximately USD 55.5 billion) increase during the first two months of the year. Compared with February, this year’s peak, holdings fell by USD 171 billion (approximately USD 176 billion), or 13.8%. They were also down USD 115.6 billion (approximately USD 119 billion) from last August, a year-on-year decline of approximately 9.8%. Japan’s share of total foreign holdings of U.S. Treasuries also fell from approximately 12.8% to 11.4% over the same period.

Table 1. China’s and Japan’s U.S. Treasury Holdings

China Focuses on Asset Diversification, Japan on Defending the Yen

China’s sales of U.S. Treasuries are seen as being driven by efforts to diversify the investment destinations for its foreign exchange reserves and prepare for the risk of financial sanctions. After Western countries froze the Russian central bank’s overseas assets in 2022, concerns grew in China that its own assets could be exposed to similar sanctions. China has accordingly reduced its Treasury holdings and broadened its investments into gold, U.S. agency bonds and equities. This diversification is also affecting the flow of dollars earned through trade surpluses back into the U.S. bond market. China has historically reinvested foreign currency accumulated through exports in U.S. Treasuries, helping finance the U.S. fiscal deficit and keep Treasury yields low. As U.S. financing needs grow, reduced Chinese purchases and sales of existing holdings would put downward pressure on Treasury prices and upward pressure on yields.

Japan may have sold U.S. Treasuries to prevent the yen from depreciating. Curbing yen weakness requires selling dollars to buy yen, so Japan could dispose of Treasury holdings to secure the dollars needed for intervention. Japanese authorities in fact spent JPY 15.4 trillion (approximately USD 99.2 billion) on foreign exchange intervention between July 30 and August 26, the largest amount on a monthly basis. Foreign exchange reserves fell by USD 79.6 billion (approximately USD 82.1 billion) that same month, with the decline concentrated in foreign-currency securities, primarily U.S. Treasuries. Market participants believe some proceeds from Treasury sales were used to buy yen, citing the overlap between the decline in foreign-currency securities and the large-scale intervention.

Sentiment Toward Long-Term U.S. Treasuries Weakens

Losses from falling Treasury prices are also increasing selling pressure among investors. Last month, U.S. Treasuries posted their worst monthly performance in four years, while the 10-year yield rose by more than 0.5 percentage points in a month to reach 5.3%. The sharp rise in yields forced some funds to reduce their bond holdings under their risk-management rules, creating a vicious cycle in which additional selling pushed prices down further. Longer-maturity bonds are particularly sensitive to interest rate changes, prompting investors to weigh the timing of purchases carefully. Even as capital flows in to lock in recently elevated yields, concerns about supply continue to weigh on 20-year and 30-year Treasuries.

Concerns that deteriorating U.S. public finances could lead to increased Treasury issuance are also weighing on sentiment toward long-term bonds. U.S. federal government debt exceeded USD 40 trillion (approximately 50 quadrillion 3, USD 485 billion) for the first time in August. With tax cuts limiting revenue growth, rising social security spending and interest costs, compounded by the burden of tariff refunds, have accelerated debt growth beyond initial expectations. As continued Treasury issuance is expected to cover the fiscal deficit, investors are demanding higher yields in return for absorbing the additional supply. Market participants are therefore watching whether the Treasury Department will reduce long-term issuance, while a mix of expectations and uncertainty over issuance plans is increasing yield volatility.

Private Capital Flows In, Seeking Interest Income and Trading Gains

As Treasury issuance increases, the composition of investors absorbing it is also changing. Foreign central banks, finance ministries and sovereign wealth funds hold approximately 12% of all U.S. Treasuries, sharply below the roughly 40% they held around the 2008 financial crisis. In particular, as demand from major holder countries such as China and Japan weakens, hedge funds are playing a growing role in absorbing the supply coming onto the market. According to the Financial Accounts of the United States released by the Federal Reserve last month, net U.S. Treasury holdings of U.S.-registered hedge funds rose from USD 102.8 billion (approximately USD 106 billion) at the end of last year to USD 108.8 billion (approximately USD 112 billion) at the end of March and USD 123.5 billion (approximately USD 127 billion) at the end of June. The first-half increase totaled USD 20.7 billion (approximately USD 21.3 billion), or 20.1% of the previous year-end balance. The quarterly increase in holdings also widened from USD 6 billion (approximately USD 6.19 billion) in the first quarter to USD 14.7 billion (approximately USD 15.2 billion) in the second quarter. On a transaction basis, excluding valuation changes caused by price fluctuations, hedge funds also recorded net purchases for two consecutive quarters.

Higher yields and arbitrage opportunities are cited as factors driving hedge funds’ purchases of U.S. Treasuries. Falling Treasury prices have increased the interest income available to new buyers, while a future decline in yields could also generate trading gains as bond prices rise. Major asset managers such as Amundi, BlackRock and PIMCO have similarly described the recent rise in yields as an opportunity to invest in Treasuries. Hedge funds also seek returns through “basis trades,” which exploit price differences between cash Treasuries and futures. This involves buying cash Treasuries while simultaneously selling futures, then profiting as the gap between the two prices narrows. Funds sometimes increase the size of these positions by borrowing against the Treasuries they purchase. Capital is thus entering the Treasury market in pursuit of interest income, trading gains and price differences between cash securities and futures. U.S. Treasuries have long been regarded as a leading destination for major exporting countries such as China and Japan to invest foreign currency accumulated through trade safely. The fact that hedge funds pursuing high returns are actively targeting U.S. Treasuries suggests cracks have emerged in the longstanding perception of them as “low-risk, low-return assets.”