ANALYSIS-As sanctions ‘weaponise’ the US dollar, some Treasury buyers may retreat

By Karen Brettell

March 29 (Reuters) – U.S. sanctions on Russia are expected to hasten some countries’ move to reduce their dependence on the U.S. dollar, which could also weaken demand for Treasuries as the Federal Reserve, the largest holder of US debt, is looking to reduce its bond holdings.

The United States and other Western countries imposed sweeping economic sanctions against Russia in response to its invasion of Ukraine, which effectively prevented Russia’s central bank, sovereign wealth fund, banks and certain people from concluding US dollar transactions.

The dollar is the world’s primary reserve currency. Analysts say using it as a financial weapon is likely to accelerate a move already underway by many countries to diversify investments into alternative currencies.

“The more we use it, the more other countries will diversify for geopolitical reasons,” said Zongyuan Zoe Liu, international political economy fellow at the Council on Foreign Relations.

The reserve status of the dollar stimulates demand for US assets, including Treasury bills, and allows the government to issue more debt at lower rates than it otherwise could. Treasuries are also attractive to investors as the market is larger and more liquid than others.

If Treasuries are less attractive to some investors just as more supply hits the market, however, the result could be higher yields.

The Fed is expected to start letting Treasuries mature without replacing its $8.9 trillion balance sheet in the coming months, in addition to aggressively raising interest rates as it tackles the surge in inflation. 10-year benchmark yields
hit 2.56% on Monday, the highest since May 2019.

While the dollar is unlikely to be replaced as a reserve currency anytime soon, any steady move away from the greenback could lead to a more fragmented global economy where payments are spread more evenly across currencies, including the dollar, l euro and the yuan.

“The depreciation of the U.S. dollar (is) the ultimate outcome as the dollar is weaponized into a new era of sanctions,” Bank of America analysts led by Michael Hartnett noted in a report released Thursday.

In a sign that change is already accelerating, The Wall Street Journal reported this month that Saudi Arabia was in talks to price the crude it sells to China in yuan.

Russia has gradually reduced its dollar holdings since the imposition of Western sanctions following Moscow’s annexation of Crimea in 2014. In 2021, it announced that it would divest all US dollar assets from its National Wealth Fund and would increase its holdings of euros, Chinese yuan and gold.

Russian Treasury holdings fell to negligible levels in mid-2018, and are down from around $150 billion a decade ago, according to data from Treasury International Capital (TIC).

Other countries also reduced their bond holdings.

China held $1.1 trillion in treasuries in January, making it the second-largest foreign owner after Japan, up from around $1.3 trillion in 2013. China bought a smaller share of the debt publicly held company, which grew to $23 trillion from about $12 trillion over this period.

Saudi Arabia held $119 billion in treasury bills in January 2022, up from $185 billion in February 2020.

Demand for bonds by oil producers in the mid-2000s was seen as key to keeping yields low even as the Fed embarked on a two-year hike cycle.

This time around, oil producers are less likely to step in, even if they benefit from soaring oil prices, said Thomas Mathews, market economist at Capital Economics.

“Sanctions on Russia will be a bit alarming for many of the major oil exporters who hold large amounts of Treasuries (and US assets in general) and could accelerate some diversification plans. This could mean that some of the support for Treasuries coming from foreign savings, as we saw in the mid-2000s, could be missing during this tightening cycle,” Mathews said.

That said, even if these countries continue to reduce their purchases of Treasuries, they should not launch large sales of bonds. There may also be limits to the extent to which countries can reduce their holdings as there are few alternatives in terms of security and liquidity.

If yields continue to climb, the bonds could attract other buyers.

“As rates rise and the outlook for an economic slowdown continues to mount, there will be diversification from risk assets into Treasuries, so yields may actually be leveling off,” Thomas Simons said. , money market economist at Jefferies. “I think it’s more of a risk for risk assets in this environment than for Treasuries.” (Reporting by Karen Brettell; Editing by Alden Bentley and Leslie Adler) ((; @BrettellKaren)) Tags: USA BONDS/DEMAND (ANALYSIS)

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