A strong dollar is making Treasurys more attractive to foreign buyers — a key source of demand as the U.S. government pumps up supply to fund the response to COVID-19 — and buoying already robust international demand for the asset class even as yields fall, according to experts.

The yield on 10-year U.S. government bonds was 1.5% as of June 22, down from a 2021 high of 1.74% in late March, as the Federal Reserve's persistent messaging that it will not look to taper its $120 billion a month asset purchase program drew in investors. Yields fall as the price of a bond rises.

The diminishing return on offer for holding U.S. debt should reduce the attractiveness of Treasurys for domestic investors. But, for money managers based abroad, the strengthening dollar — boosted by the slightly hawkish turn in the Fed's thinking, bringing forward its expectation of rate hikes to as early as next year — boosts the returns of dollar-denominated assets when converted back into their currency.

"I think perversely, even with the fall in yields, that strength in the dollar could actually be a bigger factor in driving demand," Colin Finlayson, co-manager of the Aegon Strategic Global Bond Fund, said in an interview.

The Dow Jones FXCM Dollar Index — which tracks the performance of the U.S. dollar against a basket of currencies — jumped to a near-high for 2021 following the Federal Open Market Committee's two-day meeting that ended June 16. Fed officials confirmed plans to keep rates near 0%, though a majority of the 18-member board expect the central bank to raise interest rates twice in 2023 and many see tightening starting next year.

"The balance of risk has shifted to the upside for the U.S. dollar especially if U.S. short rates continue to drift higher and price in more rate hikes into next year," Lee Hardman, currency analyst at MUFG, wrote in a June 17 research note.

Foreign investors are the largest block of holders of U.S. government debt, ahead of the Federal Reserve, U.S. investment funds and U.S. households. The depth and liquidity of the asset class are crucial for portfolio managers who want assets that they can quickly sell if they require cash. The AAA sovereign credit rating — excluding S&P Global Ratings' rating of AA+ — makes U.S. government debt one of the safest assets available.

"U.S. Treasurys will continue to attract interest simply because of the size of the market and the fact that the greenback remains the global reserve currency," Daryl Liew, head of portfolio management at REYL Singapore, said in an email.

"The strength or weakness of the dollar also does have to be factored in, as it would affect the overall returns for foreign investors ... earlier than expected tapering or normalization in U.S. interest rates could provide support for the dollar," Liew said.

Increasing demand

Japan, the largest foreign market for Treasury securities at $1.277 trillion — ahead of mainland China at $1.096 trillion and the U.K. at $431.8 billion — increased its holding by $36.4 billion in April, the latest month for which data is available. That coincided with a widening in the spread in yield between 10-year Japanese government bonds and Treasurys from 126 basis points to 163 bps over the course of the month, improving the premium for holders of U.S. government debt.

Total holdings of Treasury bills, bonds and notes by non-U.S. investors climbed by $41.8 billion in April to $7.07 trillion, 32.9% of the entire $21.3 trillion U.S. government bond market. This is down from a peak of 56.5% in the fourth quarter of 2008 as the Federal Reserve has become a significant buyer through its quantitative easing programs — both after the financial crisis of 2008-2009 and during the COVID-19 pandemic.

The trillions of dollars in extra government bonds that have been printed to fund the government's response to COVID-19 has been a test of demand, but the deluge of extra supply has so far been absorbed with foreign buyers playing an important role in Treasury auctions.

"The increased amount of Treasury supply that markets have been digesting has created occasional hiccups, including the weak 7-year note auction in February, but there is no reason to expect demand will fail to keep up with supply longer-term," John Canavan, lead analyst at Oxford Economics, said in an email.

Attractive spreads

The dampening effect of the relatively loose monetary policies of the European Central Bank and Bank of Japan on the yields of European and Japanese bonds could also see spreads widen between Treasurys and other sovereign bonds. Japanese banks are looking to the Treasurys to boost their returns.

Both central banks are persisting with asset purchases and have not hinted they will raise rates any time soon. In the case of the Bank of Japan, the stated policy is to keep yields close to 0% by buying bonds.

Government debt in the U.S. continues to offer greater returns than other AAA-rated government bonds such as Germany and Japan.

The yield on German 10-year bunds was -0.36% as of June 18, according to S&P Global Market Intelligence data. The spread in yield with 10-year U.S. Treasurys was 181 basis points, indicating a positive return for European investors in U.S. debt once hedging costs are considered.

Once hedged, 10-year Treasurys offer a yield of 0.8%, almost 100 basis points more than German bunds, according to Althea Spinozzi, fixed income strategist at Saxo Bank.

"Most investors will not want to pay for holding German bunds while they can accrue interest by holding the U.S. safe-haven," Spinozzi said in an email.