Corporate Cash, Taxes and US Treasury Yields

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A majority of Federal Reserve officials expect that conditions will warrant two more hikes this year.  That would put the Fed funds target range at 1.25%-1.50% at year-end.  Yet the two-year note yields less than 1.3% and the 10-year yield has been struggling to sustain gains above 2.30%.  

Several central banks, including the People’s Bank of China and the Bank of Japan, have been reducing their holdings of US Treasuries. Many observers feared this scenario, but the Treasury market has absorbed the sales without much fanfare.  It would imply that other buyers have emerged. 

Saudi Arabia is interesting.   In the first three-quarter of last year, Saudi Arabia sold almost $35 bln of US Treasuries.  However,  in the September 2106-February 2017, according to the US data, they bought back nearly $24 bln of US Treasuries.

The Federal Reserve’s custody holdings of US Treasuries for foreign official accounts has risen by nearly $135 bln since the US election last November.  The holdings as of last week were the highest since last August.

Despite the Fed’s hikes, two since the November election, the interest rate for small savers have barely gone up.  The only way to get a better return is to take on more risk.  The additional risk through the quality of the asset or the duration.  Many Americans appear to be taking the second course.  Bond funds (active managers and ETFs) took in about $47 bln in Q1 17, according to reports, which is the most for any quarter since 2013.  Equity funds experienced a $60 bln liquidation in Q1.  In all of 2016, fixed income funds and ETFs reported inflows of $52 bln.

There is another source of demand for Treasuries that is often overlooked.  Many of us have this (old) idea that corporations are takers of liquidity from the market.  They are borrowers.  However, the story is considerably more complicated.  Consider that Corporate America has an estimated $2.0-$2.5 trillion offshore.  The bulk of which is stored in dollar-denominated instruments.  The  top

seven tech companies had about $555 bln offshore at the end of 2016, according to Bloomberg data, and owned about $200 bln of Treasuries at the end of last year.

According to personal knowledge, anecdotal evidence, and reports, most of the cash retained by US corporations outside the US largely placed in dollar-denominated instruments.  Apple, for example, which has largest cash stockpile offshore is thought to have nearly 90% of its $250 bln in dollar-denominated instruments.  This is one of the reasons many economists do not expect a tax holiday to encourage repatriation to boost the dollar directly.  There may be some indirect impacts, such as a smaller current account deficit, that could have an indirect impact.

It appears that Treasury Secretary Mnuchin has a similar penchant for exaggeration as several others in the Trump Administration.  Mnuchin said that the tax holiday on foreign earnings could see trillions of dollar repatriated.  In theory yes, if all of the money was repatriated.  However, in practice, this is unlikely.  In 2004, the last such tax holiday, nearly 850 companies took advantage of the break and repatriated 35% -40% of the eligible funds or some $312 bln.

What did companies do with the repatriated funds?  Share buybacks accelerated.  Studies, including by the Congressional Research Service, found new hiring and investment did not live up to the expectations.  Two large drug companies, for example, repatriated about $53 bln and cut 17k jobs.

To summarize, we make three points.  First, the market has easily absorbed the sales of Treasuries by the two largest foreign holders, Japan and China.  Other central banks have been buying, judging from the Fed’s custodial holdings.  Second, domestic demand is robust.  Bank holdings of Treasuries have increased, and actively managed bond funds and ETFs experienced the most inflows in Q1 in nearly four years.  Third, US corporates hold $2.0-$2.5 trillion offshore.  The vast majority of these funds are invested in US dollar denominated instruments, including US Treasuries.  This is part of the reasons that a tax holiday on such earnings will only increase demand for dollars on the margin.