Nobody Just Sold $100 Billion Of U.S. Treasuries

In the week through Wednesday, March 12, the amount of U.S. Treasury securities held in custody for foreign official and international accounts (i.e., central banks) at the Federal Reserve dropped by a staggering $104.5 billion, marking what was far and away the biggest weekly drop on record.

These custody holdings have fallen almost every week since mid-December, as weakness in emerging-market (EM) currencies has caused EM central banks to raise dollars by liquidating their U.S. Treasury holdings, and then turn around and sell those dollars on the open market in order to prop up their own currencies.

This has prompted some speculation that central banks selling Treasuries were behind the record drop in Fed custody holdings. However, such activity doesn't come close to explaining what happened in the last week.

For example, the Central Bank of Russia - which has been in the spotlight due to escalating military tensions in Ukraine and has thus seriously underperformed against other EMs as of late - only bought 154.97 billion rubles in the week ended March 12.

At an average exchange rate of 36.35 rubles to the dollar over that time period, the CBR's intervention amounted to about $4.3 billion - leaving more than $100 billion of the drop in Fed custody holdings unaccounted for.

The second-largest weekly drop in Fed custody holdings of U.S. Treasuries for foreign official accounts on record took place in the week ended June 26, 2013. Recall that June 2013 was a period of significant, widespread stress in emerging markets on the back of assertions by then-Federal Reserve Chairman Ben Bernanke that the U.S. central bank would likely begin winding down its quantitative easing program later in the year.

During that week in June, JPMorgan's Emerging Markets Currency Index fell as much as 2.5%.

Over the week ended March 12, 2014, on the other hand, the index fell only 0.6%. Moreover, traders on U.S. Treasury desks were unaware of any unusual central bank flows this week - meaning "firesales" of U.S. Treasuries by EM central banks appears to be an insufficient explanation for the large drop in holdings.

The most likely explanation for the drop in custody holdings is that Russia moved its U.S. Treasuries outside of the U.S., so that if and when the West levies financial sanctions against it as a result of escalating military tension in Ukraine, Russia will still be able to access its money.

BofA Merrill Lynch interest rate strategists Shyam Rajan and Priya Misra make two points to that effect in a note to clients (emphasis added):

1) Although large shifts out of the New York Fed custody are rare, we have seen custodian shifts elsewhere, recently. For example, the December 2013 TIC data showed a massive increase in Belgium's Treasury holdings (higher by $57 billion), matched by a drop in China's holdings (-$48 billion). Given that Belgium's reserves total less than $20 billion, the spike higher was likely a shift in custodians by a major reserve manager. The recent shift could be also be a similar large reallocation to a different custodian.

2) The upcoming referendum in Crimea this weekend and the multiple threats of sanctions could have triggered a significant reallocation of Treasuries to a non-U.S. custodian. Note that custodian banks are not allowed to transact with entities listed in the OFAC list, once sanctions are imposed.

What impact does all of this have on the market?

"A mere shift in custodians should not have any impact on yields in the Treasury market," say the BofAML strategists.

"A consistent move out of the New York Fed merely diminishes the reliability of this indicator as a high frequency source for foreign official demand."