400 Billion Reasons Why Ebbing Currency Reserves Threaten Bonds

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There’s a $400 billion reason to worry if you’re a bond investor.

That’s how much global currency reserves have shrunk since reaching a record $12 trillion last August, according to data compiled by Bloomberg.

The decline is another potential source of volatility in debt markets rocked this week in part by ebbing deflation fears in Europe and speculation the U.S. Federal Reserve will soon raise interest rates.

That’s because contracting reserves leave countries with less money to recycle into bonds, removing a key support, strategists at Montreal-based brokerage Pavilion Global Markets Ltd., said in a note sent to clients on Thursday and titled “Falling Reserves, Rising Yields.”

Periods of falling reserves historically coincided with increased fixed-income volatility, as measured by a market stress indicator created by the ECB and based on fluctuations in the German 10-year bond, according to the Pavilion team, led by Pierre Lapointe.

Bond markets jumped in both 2008 and 2011, the same times as the combined reserves of China, Saudi Arabia, Japan and Switzerland were dipping by Pavilion’s reckoning.

“We expect this time to be no different,” Lapointe and colleagues wrote, predicting a more skittish bond market will also cause equities and currencies to trade more wildly.

Furthermore, they found recent outflows from Europe’s bond market correlate with monthly declines in China’s foreign-exchange reserves, which have fallen to $3.7 trillion from a peak of $4 trillion last June.

Emerging markets exiting European debt “could explain the recent move in bund yields despite underwhelming data and continued Greek drama,” the Pavilion strategists wrote.

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