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A Delicate Balance for the Treasury

The President will face a delicate balancing act when his fiscal and trade proposals meet the reality of the Treasury market's supply and demand. The "conundrum" of interest rates remains more than a decade after the Fed Reserve chairman issued the words to describe the historically low long-term interest rates of four percent at that time. Recent upward movements have brought yields into better alignment with nominal GDP growth; however, whether this result is from the expectation of higher supply or lower demand for Treasuries remains uncertain. Alternately, the increase in interest rate may simply be a risk premium for holding Treasuries in the face of uncertain policy actions.

Trading Places. Free markets use price as a signal to determine how to allocate capital. Determining a price and allocating capital becomes difficult when labor is not mobile, the currency is fixed, and capital accounts are restricted. While the US is the beacon for free markets, possessor of the global reserve currency and an open capital account, not all its trading partners play by the same rules, in particular, China.

As the economic models predicted, China's entry into the WTO in 2001 brought increased trade with the US and the world. China leveraged its factor of production advantage with excess labor by exporting goods and services at a lower cost that reduced import pricing pressure for the US. The increased trade permitted China to turn farmland into a megalopolis.

Fixing Prices. China followed another economic model when it set the currency to the US dollar and restricted the capital account. The trilemma permitted them to keep their interest rates low and control the domestic monetary policy without the outside influence of capital flows. These actions also allowed them to spur domestic investment to unprecedented levels.

China needed to do something with the excess US dollars that they were receiving from trade. The natural place for the dollars was to buy US Treasuries. China did this with gusto and soon surpassed Japan to became the largest holder of US Treasuries. Unrecognized was that the US had effectively seeded control over its Treasury market to external holders, China and Japan.

Driving Demand. The Federal Reserve announced the cessation of the bond buying program (‘quantitative easing’) at their meeting in October 2014. This change was material, as the Fed is the largest holder of US Treasury securities with an amount more than the next three largest holders combined. With Chinese demand waning as well, demand must unambiguously go lower.

While the two largest purchasers are reducing their purchases, others may fill the gap. Global banking regulations are giving a lift to government bonds in general, while low or negative interest rates in Europe are enticing their investors to seek out yield in the US. Japanese investors face similar meager yields and with a major investor (the Japan Postal Office) diversifying away from its holdings of Japanese government bonds. Of course, US corporate pensions still need their share of bonds to service their liabilities.

The demand for Treasuries though can't escape from the fact that a holder of about one-third of the issuance and another with about one-eighth are stepping away from the purchases. The sheer size of those leaving limit the impact of the players entering. So, demand appears a headwind either way.

Supplying Demand. As the composition of demand has changed over time, so has the supply of US Treasuries. The US Treasury met the higher demand with increased issuance to support growing deficits. Since 2009 the tide has turned as the deficits reached sustainable levels as tax revenue climbed to new heights.

The lower deficits were the result of two different forces at play. Over the last five years, Federal government expenditures saw the lowest growth rates in fifty years. Since exiting the Great Recession, corporate taxes more than doubled from the trough in 2009, while individual tax receipts nearly achieved the same outcome. Even custom and excise taxes reached new highs. The reduction of the deficit results in lower rate of issuance of Treasuries, which is timely as the Treasury demand starts to dwindle.

The starting point for supply is not helpful. The current federal debt of the US is at the highest level of any non-war period, whether measured in absolute terms or relative to GDP. Fortunately, interest payments were well contained in the face of rising debt levels as lower interest rates reduced the cost to carry the debt. Of course, it was the Federal Reserve's monetary policies of quantitative easing and setting of the Federal Funds rate that reduced interest rate costs to meet their objectives of full employment and price stability.

Capital Risk. With the current proposals under discussion, the forces at play for the last few years seem destined to reverse. On the revenue side, corporate and individual tax cuts are expected, which would lower the receipts under most projections. Of course, when the expenditure side is expected to increase dramatically as well, the deficits may accelerate wider than anticipated, which is a recipe for a higher supply of Treasuries.

The principal foreign actors, China and Japan, do have some say in the outcome. While Japan remains a relatively captive buyer, it is China where change is reversing a decade-long trend. The Chinese central bank is now selling US dollars and Treasuries to support the currency from falling. This action is a poor indication of future Treasury demand as a stabilizing economy is expected to reduce the amount of future selling required.

While the Fed is in unprecedented territory, they still control the largest amount of Treasuries and the level of interest rates through their open market operations. Interest rates will go where they dictate as long as their objective is unchanged and the Fed has indicated that the current proposals from the President would cause them to increase interest rates as the level of debt moves dramatically higher and inflation accelerates under tight labor conditions. Higher interest rates, inflation, and a fiscal crisis as interest payments increase, would make an economic boost turn into an economic bomb.

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