There was brief noise to this effect in the first quarter as China suggested, possibly as leverage in the tariff negotiations, that it might curtail the purchase of Treasuries. Yields rose on the news, though this was against a backdrop of a jittery market. Nonetheless, one nightmare scenario for rates has been suggested as China dumping Treasuries to show its financial muscle and make a political point.
While we cannot dismiss this possibility, we see it as extremely unlikely. John Maynard Keynes once commented that “if you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.” If this observation is right, China has a problem. Selling off their Treasuries would result in a massive loss and further, given the nature of their economic reliance on developed world importation of goods and the developed market’s reliance on the stability of the U.S. financial markets, we view this as an unlikely threat from China. Further, given the broader global reliance on Treasuries, other large players, including central banks, could step in to moderate the volatility.
China, or other sovereign buyers, stepping back from purchases could impact Treasury rates in cases when they represent the marginal buyer, but otherwise it would remain among a myriad of factors to consider. Ironically then, these buyers could potentially do more damage, rather than by selling Treasuries, if they unexpectedly and significantly increased purchases of Treasuries and triggered an inverted curve, prompting the fears associated with inversion.
Reality stone: Does Treasury supply matter?
Earlier this year, Congress passed a budget, which was projected to expand spending by $300 billion over the two-year deal. This increase in expenditures came shortly after tax reform passed last year. While the stimulative effects of tax reform could increase government revenue somewhat, this combination nonetheless suggests larger deficits and therefore more issuance of Treasuries. Indeed, through the end of June, the Treasury had already issued $480 billion in net new Treasuries after net issuance of $537 billion in all of 2017. Despite record tax collections in April, in July, the Treasury raised its estimate of borrowing for the year to $1.33 trillion.
At its most basic levels, markets being the balancing of supply and demand, this should suggest upward pressure on rates. However, in examining the five years when the Treasury issued over a trillion of net new debt (2008 – 2012), it is somewhat counterintuitive to observe that in all of these years save 2009, interest rates actually declined (2018 is on pace to be the second). Is it that issuance is positive for rates? That seems unlikely, but rather to current markets, issuance is one among many characters in this narrative as opposed to the lead.
Nor is the debt issue new to the last decade. The famous debt clock in New York, which tallies the national debt in the U.S., goes in and out of favor as a novelty to highlight the country’s fiscal woes. However, far from being a recent phenomenon, the clock was actually created in 1989 (an additional digit had to be added in 2008.) Indeed, the issue of fiscal deficits was acute enough in 1984 that President Reagan addressed concerns by quipping, “I am not worried about the deficit. It is big enough to take care of itself.” Since 1981, when outstanding U.S. Government debt hit $1 trillion (not adjusted for inflation) for the first time, the U.S. government debt has grown by a factor of 20 (unadjusted) and debt as a percent of GDP has grown from 31% to 104% at the end of 2017. At the same time, Treasury interest rates—the cost to finance that debt—has fallen 80% despite what a 1984 New York Times article described as “a huge budget deficit that helps keep interest rates up.”
While many continue to say this increase in debt is unsustainable, markets are yet to be especially concerned. Debt-to-GDP is likely to be a ‘tipping point’ type discussion, where markets do not care about debt levels until they suddenly care very much. It is unlikely to be predictable what that magic number is, broadly speaking, but it seems highly likely that whatever the ratio is globally, the U.S. dollar’s status as reserve currency and Treasuries as the premier flight-to-quality asset make the ratio somewhat higher for the U.S. So, while supply must matter in an economic sense, it has yet to be more than an issue on the margin. Treasury bonds, much like Marvel movies, will continue to be produced as long as people keep buying them.
Treasuries outstanding vs. funding cost (10 year)