NEW YORK, Jan 30 (Reuters) - Foreign central banks slashed their holdings of U.S. debt stored at the Federal Reserve by the most in seven months during the past week, leaving these so-called custody holdings at the lowest level since November, Fed data released Thursday showed.
The drop, the sixth weekly outflow in a row, comes against a backdrop of enormous volatility in foreign exchange markets, particularly in emerging market currencies. This has forced a number of central banks to spend from their reserves to defend their currencies against excessive weakness.
"It makes sense," said Scott Carmack, fixed income portfolio manager at Leader Capital in Portland, Oregon, which has $1 billion under management. "It will probably continue as emerging markets try to prop up their currencies."
Overall foreign holdings of securities such as Treasuries, mortgage-backed securities and agency debt at the Fed fell by $20.77 billion to $3.325 trillion in the week ended Wednesday, led by a $20.66 billion drop in Treasury holdings. It was the largest weekly decline for both since June.
Foreign central bank holdings of Treasuries at the Fed totaled $2.973 trillion.
Both Treasury and overall holdings were the lowest since mid-November and have fallen for six straight weeks, ever since the Fed's monetary policy arm, the Federal Open Market Committee, announced on Dec. 18 that it would begin scaling back its massive bond-buying program known as quantitative easing.
Total holdings have fallen by nearly $55 billion from a record $3.38 trillion on the week that ended when the Fed made its announcement. Treasuries account for some $48 billion of that total decline.
On Wednesday, the FOMC said it would reduce its purchases of Treasuries and debt backed by Fannie Mae and Freddie Mac by another $10 billion per month starting in February, bringing the monthly run rate of purchases down to $65 billion. Before it began tapering the program, it had been buying $85 billion a month, and the Fed's balance sheet has swollen to more than $4 trillion.
Through its purchases of safe assets like Treasuries, which drove U.S. bond yields to record lows, the Fed has essentially forced investors to seek higher yields elsewhere, in other assets such as stocks and in other regions. Emerging markets became a favorite destination for these so-called hot-money flows.
With the Fed now reducing its stimulus, those flows have dramatically reversed in recent months, picking up significant momentum in the last week, and leading to fierce bouts of volatility.
In response, several emerging market central banks executed extraordinary interest rate hikes this week in an effort to stem the selling of their currencies. Turkey, for instance, raised its key overnight lending rate to 12 percent from 7.75 percent, and South Africa and India also lifted rates sharply.
"They can generally do this in one of two ways," Carmack said. "The hardest but most effective way is to raise interest rates as they did in Turkey and India. That's obviously a growth negative and in the near term causes pain. Central banks often will take the easier path of liquidating dollar reserves to buy back their own currencies to prop them up."