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With Trade Deficits Soaring: Who Will Buy US Treasuries?

"Will there be a mismatch between what the U.S. wants to sell (Treasuries) and what the world wants to buy?"

Brad Setser asks the above question in his "Follow the Money" post How Will the U.S. Fund its Twin Deficits?

In the past few years, the U.S. Treasury has needed to, on net, raise about three percent of U.S. GDP from the market to fund the budget deficit. A portion of the deficit has been funded with short-term debt, so funding deficits of that size have required roughly 2 percent of GDP per year in (net) issuance of Treasury bonds and notes.

The external deficit could be financed by selling off equity, but, by and large, it hasn’t been—U.S. purchases of foreign equity and foreign purchases of U.S. equity have tended to largely offset, so the bulk of the current account deficit has been financed through the sale of bonds to the world.

Since 2014 the inflow has been into Agencies and corporate bonds. Obviously, the question of who is going to buy all the bonds the Treasury will issue has gained additional prominence recently.

The fiscal deficit is rising toward 5.5 percent or so of GDP, which implies that the Treasury will need to sell about 4 percent of GDP of bonds (on net) a year—not the roughly 2 percent of GDP it now sells. These numbers assume—based on some work that Goldman Sachs has done—that increased bill issuance can cover around 1.5 percentage points of GDP of the annual funding need, so “note” and “bond” issuance will lag the headline fiscal deficit. ​

On the other hand, the Fed will be cutting back its Treasury portfolio at an annualized pace of $90 billion a quarter, or a bit under 2 percent of GDP once the roll-off is fully phased in. The market consequently will likely need to absorb over 5 percent of GDP of longer-dated Treasury issuance—a real step up from the current level.

What Will Give?

Setser mentions four possibilities.

  1. Central banks return to buying large quantities of reserves, and those reserves are funneled into the Treasury market. That probably would require that the U.S. Treasury soften its criteria for determining manipulation, or for a host of countries to conclude that there is little to fear from that designation.
  2. Higher rates induce private investors globally to buy more Treasuries.
  3. Private investors abroad will continue to buy U.S. corporate bonds and start becoming net buyers of U.S. equities rather than Treasuries, and, as the price of these assets rises relative to the price of Treasuries, Americans will conclude Treasuries are a comparative bargain and snap up the full increase in supply.
  4. The Treasury could really shorten the maturity of its portfolio and issue a ton of bills rather than notes (offsetting the reduced supply of zero duration reserves associated with the Fed’s balance sheet reduction).

Inverse Trade Balance

Match Setser's chart with the following inverse chart of the trade deficit.

The inverse Balance of Trade and and Setser's chart are nearly identical.

Given the deficit, it's a mathematical necessity that foreigners will accumulate US assets, typically treasuries or agencies, but it could be equities or corporate bonds.

Most of that "dumping" of US treasuries is related to Chinse selling of US treasuries to stop capital flight.

Capital Flight

If capital flight from China picks up again, China will again sell treasuries, not corporate bonds.

Who Will Buy Treasuries?

  1. China, Europe, Japan, any country running a surplus, unless capital flight gets in the way.
  2. If corporate bonds, especially junk, get hammered as I expect, treasuries will increasingly look attractive to both foreign and domestic buyers.

Faulty Assumptions

Setser seems to believe the Fed's asset sale will go on schedule. Will that happen?

What if recession hits? Will the Fed dump assets or buy more of them?

The question "who will buy" is interesting, but Setser missed a key point about capital flight.

Also, Setser presumes the Fed's asset reduction plan will go on schedule.

I suggest "It won't."

Regardless, it is a mathematical necessity that someone will buy any treasuries the Fed issues.

Since I expect a stock market bust and a recession, I expect yields will be lower, the exact opposite of what most expect.

Meanwhile, ongoing talk of "nuclear" dumping of treasuries by China is preposterous.

Pent-Up Demand

  1. Expect China to buy more treasuries because the US Trade deficit is increasing.
  2. European Junk Bonds have a yield less than US treasuries: Too Safe to Fail: Implied Default Rate for European Junk Bond is Negative 1.1%
  3. Also remember the global equity bubble. The stock market is likely to sink by two-thirds says John Hussman: Sucker Traps and the Arithmetic of Risk.

Assuming Hussman is correct, and I believe he is at least close, here's my proposal: Inflation Coming? How About Deflation?

I sense a huge pent-up demand for treasuries.

Mike "Mish" Shedlock

I used to read Brad a decade or so ago. He knows his stuff when it comes to current accounts and money flows. He's just posting his views based on what's currently planned to happen. And he's absolutely right. How are we going to finance the government in 2019? That's completely unknown at this point. Something will have to change from the current plan.

ok , maybe a dumb question, but what compels china or any other country to purchase US assets with the dollars they accumulate ? could they take the dollars and sell them in the forex market for euros and buy euro assets ?

"Setser seems to believe the Fed's asset sale will go on schedule. Will that happen? "

What asset sale? They are allowing MBS and Treasuries to run off as they mature but I'm not aware of any planned sales.

There is a 5th possibility. Commercial banks buy bonds with excess reserves. These will decrease as the Fed shrinks its balance sheet but they have already said they will stop the run-off at a higher level than before the GFC.

I have a comment, and a question. First, the comment. Mish, you say "The inverse Balance of Trade and and Setser's chart are nearly identical." They are, until the last 5 years or so. During the last five years, purchases are way less that you'd expect from the balance of trade. That implies that some are buying other assets, such as companies or real estate.
Now, my question. Between 2018 and 2032, the Social Security Trust fund will have a dramatically negative cash flow. They have traditionally been a major buyer of US treasures. They will become a major seller of them. How is this accounted for, in estimating how much foreign buying will be required in the years ahead?

"They are, until the last 5 years or so. During the last five years, purchases are way less than you'd expect from the balance of trade."

I explained the difference. China sold treasuries to halt capital flight. SS has nothing to do with the issue yet. Besides, there is no fund and there is no trust.

In the end it is the effect on interest rates that is decisive not least because higher interest rates increases the budget deficit automatically. I continue to contend that at current levels of inflation 10 year rates at 2.8% will arrest economic growth

I believe the Fed's primary dealers are required to bid for any bonds that aren't doing well at auction.

I agree that there is a pent-up demand for Treasuries. Heck, when there was a panic about the US defaulting on its debt during one of those debt ceiling fights, the long-term Treasuries went UP! One of my friends had shorted TLT and had to rush to cover at a significant loss.

"SS has nothing to do with the issue yet. Besides, there is no fund and there is no trust. " The Social Security Trust Fund has been "invested" in US Treasuries. During the last thirty years, as baby boomers worked through their productive years, it has had a positive cash flow, making it a constant buyer of Treasuries. That reduced the need for foreign buyers to finance the deficit. Critics say that the government spent the social security trust fund, because in essence they did, but on paper, the Trust fund exists, and is invested in Treasuries.
With baby boomers beginning to retire, the fund now has outflows, but it will soon become a torrent. By 2020 the outflows will be massive. That will require the SS Trust fund to liquidate their entire holdings of Treasuries. If you take the view that the Trust fund exists, then, in addition to the government issuing large numbers of bonds, the SS Fund will also be selling large numbers of bonds, meaning an even larger number of bond buyers will be needed.
If you take the view that the Fund doesn't really exist, and the money has already been spent, then the Government as a whole must sell enough bonds to finance not only the deficit, but also the SS outflows. Thus, if the government is running a deficit of 5% of GDP, and SS is selling about 1.5% of GDP a year in bonds, buyers will be needed to purchase bonds totalling 6.5% of GDP.

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