Are Foreign Central Banks Slowing dumping Treasuries

Each week the Federal Reserve provides an updated number for its Custodial Accounts. A very crude way of understanding these is to consider them as a type of savings account for Foreign Central Banks that are held at the New York Branch of the Federal Reserve.

When the US buys goods from a foreign country and pays for those goods with US Dollars, oftentimes it ends up running a trade deficit with that particular nation. The result is that the foreign country ends up with a large amount of Dollars that it needs to "sterilize" in order to prevent an inflationary outbreak. What generally happens with a good portion of these surplus Dollars is that the country in question will purchase US Treasury obligations. That way it gains interest on its trade surplus of US Dollars which constitute part of its overall reserves.

For the sake of simplicity and convenience, the Treasuries are not actually shipped over to that country but are instead held "in custody" for that nation with the New York Branch of the Federal Reserve. Selling the Treasuries in question becomes very easy for the foreign Central Bank as it simply phones or wires  in its instructions and the deal is done.

Note the nearly exponential growth in the number of Treasuries held in these custodial accounts. As you can clearly see, beginning with the credit meltdown here in the US in the summer of 2008, the line has gone parabolic. This is a picture of the amount of indebtedness generated by the US as it took the path of enormous deficit spending to keep the liquidity flowing into the markets.

What strikes me about this chart is that for the last 3 years, the growth in the size of these custodial accounts has been steadily upward with only a few brief periods during which it was interrupted. Even at that, the line on the chart really never dipped all that much moving more or less sideways for a brief interval before resuming its upward path.

However something noteworthy now appears to have been underway since September of this year. The amount of Treasuries held in custody for these foreign Central Banks now appears to be slowly, but steadily declining. It reached a peak of $2.752 trillion the first week of September this year and has now declined to $2.67 trillion as of this week. That is a drop of $82.5 billion.

I do not know the exact composition of these custodial accounts in terms of the duration of the bulk of these Treasuries but I am fairly confident that there is a pretty good mix of both shorter dated and longer dated securities. The Federal Reserve's Operation Twist is designed to purchase $400 billion of longer dated Treasuries as it sells the same amount of shorter dated Treasuries.

I wonder if we are seeing foreign Central Banks using this Operation Twist to unload some of their longer dated Treasuries into the hands of the Fed. The Fed is basically buying, no questions asked. If you plan on getting rid of some of them, why not take advantage of the program?

It might be a bit too early to say with certainty, but if this is the beginning of a trend, it will signify that we are headed for a period of rising interest rates as it is doubtful that the Fed alone could soak up the Treasuries that foreign Central Banks might choose to unload if they begin getting nervous about the prospects of the US Dollar in the months and years ahead.

Stay tuned.