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.
- 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.
- Higher rates induce private investors globally to buy more Treasuries.
- 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.
- 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.
My December 7, 2016 article China Spotlight: Capital Flight Intensifies, US Treasury Reserves Plunge, Capital Controls Increase came up first in the list.
If capital flight from China picks up again, China will again sell treasuries, not corporate bonds.
Who Will Buy Treasuries?
- China, Europe, Japan, any country running a surplus, unless capital flight gets in the way.
- If corporate bonds, especially junk, get hammered as I expect, treasuries will increasingly look attractive to both foreign and domestic buyers.
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.
- Expect China to buy more treasuries because the US Trade deficit is increasing.
- 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%
- 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