Michele Kearney's Snuffysmith's Blog

BLOOMBERG

10/9/07

Treasuries Fueled by Petrodollars From Mideast Funds

Daniel Kruger

The biggest quarterly rally for U.S. government securities in five years is getting an extraordinary boost from the burgeoning reinvestment of petrodollars by the Organization of Petroleum Exporting Countries.

OPEC members increased their holdings of Treasuries 12 percent this year through July to $123.8 billion, Treasury Department data show. The prospect that OPEC's share of U.S. debt is growing is based on the 31 percent rise in oil since December, which will raise OPEC revenue 4 percent to $630 billion this year and 9 percent to $688 billion in 2008, according to estimates by the U.S. Department of Energy.

Petroleum exporters are adding to holdings of U.S. debt three times faster than other foreign investors, the Treasury data show. Yields on 10-year notes are 21 basis points lower because of the additional petrodollar reinvestment, New York- based consulting company McKinsey & Co. said last week.

``Oil revenues are up; they're still in dollars and it has to be put to work,'' said David Ader, head of U.S. government bond strategy in Greenwich, Connecticut, at RBS Greenwich Capital, one of the 21 primary dealers that underwrite U.S. government debt. ``It bodes well for U.S. debt.''

Demand from oil exporters may help drive yields lower even as signs the U.S. economy is weathering the worst housing market in 16 years reduce investor expectations for lower interest rates. The chances that the Federal Reserve will lower its target rate for overnight loans between banks this month fell to 38 percent from 74 percent a week ago, based on prices at the Chicago Board of Trade.

OPEC's Windfall

The yield on the benchmark 4 3/4 percent note due in August 2017 rose 4 basis points last week to 4.64 percent, according to New York-based bond broker Cantor Fitzgerald LP. The price, which moves inversely to the yield, fell 10/32, or $3.13 per $1,000 face amount, to 100 7/8. A basis point is 0.01 percentage point. In trading today, the yield fell almost 2 basis points, or 0.02 percentage point, to 4.62 percent.

OPEC's windfall suggests there will be demand for U.S. debt from international investors even as the dollar falls to a record low versus the euro, said Michael Pond, a debt strategist at Barclays Capital Inc. The London-based firm is also a primary dealer. Among foreign holders only Japan, China and the U.K. own more Treasuries than the 12 members of OPEC, which supplies more than 40 percent of the world's crude.

Recycled Petrodollars

Oil exporters eclipsed Asian nations last year as the biggest source of global capital for the first time since the 1970s, McKinsey found. At $70 a barrel, $628 billion of fresh petrodollars will flood through global financial markets yearly, McKinsey said.

Crude oil for November delivery closed yesterday at $79.02 a barrel on the New York Mercantile Exchange, after touching $83.90 on Sept. 20, the highest since the contract started trading in 1983 and up from about $18 in 2002. It was at $79.64 a barrel in New York today.

``The amount of money going into OPEC is just huge,'' said E. Craig Coats Jr., the co-head of fixed income at New York-based securities firm Keefe, Bruyette & Woods Inc. who started in the bond business in 1969. Their purchases have ``to do with the safety and security of our country. The U.S. dollar market is probably the most liquid,'' he said.

OPEC's members, including Saudi Arabia, Kuwait and Venezuela, bought a net $13.6 billion of Treasuries this year through July, the most recent period for which data are available, according to the U.S. government. They have purchased $45.6 billion more than they have sold since the end of 2005, or 29 percent of the $155.6 billion increase overall. About $4.5 trillion in marketable Treasuries are outstanding.

Global Banking Center

The actual holdings may be larger. A chunk of Treasuries owned in the U.K., which rose by $117.5 billion to $210.1 billion, represents recycled petrodollars, said T.J. Marta, a fixed-income strategist at RBC Capital Markets in New York, the investment-banking arm of Canada's biggest lender.

London's status as a global banking center and its overlapping market hours with Asia and the U.S. attracts money from the Mideast, Marta said.

The risk for bond investors is that OPEC members may seek better returns elsewhere after Treasuries gained 3.8 percent last quarter, including reinvested interest. The rally pushed 10-year yields down to 4.297 percent on Sept. 10, the lowest since January 2006.

Sovereign Funds

``Those dollars are going to be flowing into other assets,'' said James Sarni, a senior managing partner at Payden & Rygel in Los Angeles who helps manage $54 billion. ``There are a lot of bargains out there'' in areas such as corporate debt, he said.

U.S. company bonds yield 206 basis points more than Treasuries of similar maturity on average, 57 basis points higher than at the start of July, Merrill Lynch & Co. index data show.

Some OPEC nations are also investing through sovereign wealth funds such as the Abu Dhabi Investment Authority. The Qatar Investment Authority last month bought 20 percent of London Stock Exchange Plc, a transaction valued about $1.2 billion.

``That's where we're going to see more of these dollars going, particularly the longer government yields stay lower,'' Sarni said.

OPEC has so much influence in the Treasury market that the 10-year Treasury note had its biggest decline since June on Sept. 20 after London's Daily Telegraph newspaper reported that Saudi Arabia may stop linking its currency to the dollar. The paper cited analysts it didn't identify.

Currency Peg

Besides Saudi Arabia, OPEC members Qatar and the U.A.E. link their currencies to the dollar, meaning that as the U.S. currency weakens their imports cost more, fanning inflation. Consumer prices in Saudi Arabia, the biggest Arab economy, rose in August at the fastest pace since at least 2002, according to the Department for Statistics.

Ending ties to the U.S. currency would give less incentive to buy Treasuries. The Kuwaiti dinar has risen 3.4 percent since the country ended its peg to the dollar in May. Iran wants to avoid dollars. The second-biggest OPEC producer after Saudi Arabia is selling 65 percent of its crude in euros and 20 percent in yen, according to the country's Oil Ministry.

Saudi Arabia will keep its ties to the dollar to ensure ``local stability, transparency and investor confidence,'' Saudi Arabian Monetary Agency Governor Hamad Saud al-Sayari said in an interview with Al-Arabiya Television on Sept. 26.

`Very Conservative'

``The Saudi central bank is very conservative in its investments, and Treasuries have always provided safe returns,'' said John Sfakianakis, chief economist in Riyadh at the Saudi British Bank, the kingdom's fourth-largest lender by market capitalization. ``This situation isn't going to change anytime soon.''

Bond traders also see oil prices as a brake on consumer spending and the economy, rather than fueling inflation as in the 1970s and 1980s, Keefe Bruyette's Coats said. Consumer prices rose 2 percent in August from a year earlier, the least since November, data compiled by the Labor Department and Bloomberg show.

Three decades ago, traders would sell bonds when ``there was a whiff of inflation,'' said Coats. ``They didn't think of it in terms of having less spending money for other things,'' he said in reference to rising energy prices.