Will the U.S. Have Troubles Soon Financing Its Debt?

US Treasury Department Building, Washington, DC
Photo Credit: Flickr.com/romanboed

A nightmare seems to be stalking the executive and legislative branches of the U.S. government. Is it possible they soon may not be able to find enough suckers to buy their debt, making it impossible for them to spend at the rate they have been? And suckers they would have to be  to buy U.S. treasuries with their incredibly low yields. Yesterday the Wall Street Journal reported yields on long-term 10-year treasuries hitting a five month low below 2% (1.982% in late afternoon trading). Short-term returns are even worse with 3-month treasury bills having yields of 0%, and annualized yield for the 6-month bills of 0.081%. Even with a current inflation rate in a range between -0.1% and 0.2%, the real rates of return range from sightly negative (you have to pay Uncle Sam for the privilege!) to microscopically minimal. How could anyone be so incredibly stupid as to “invest” in these securities?

Well, maybe I would. If I needed some totally safe way to park a large amount of money for a short time, given all the turmoil and hazard in the stock market, I might consider such an absolutely safe mattress in which to stuff my money. But for foreign central banks to stick their money there would be the height of stupidity. Central banks have options you and I do not have. The only reason for a sovereign wealth fund to invest in U.S. government treasuries is to earn U.S. dollars for their foreign reserves. If they can not earn any dollars by doing it, why should they buy U.S. government debt?

In addition, foreign governments have some other urgent problems to solve which require them to sell U.S. dollars to defend their currencies. China is an excellent and probably the biggest example. Capital allocation is a rather murky affair in China, with the Chinese government trying to direct capital flows through state-owned investment banks. It should be no surprise then that a great deal of wasted malinvestment of scarce Chinese economic resources were made. Approximately $6.8 trillions worth of waste. That is the amount estimated in a joint report by China’s National Development and Reform Commission and the Academy of Macroeconomic Research. That is about 40% of the U.S. GDP and two years of output for the entire German nation. This horrendous quantity of waste is approximately half of all Chinese investment in the years covered by the report between 2009 and 2013. It is no wonder the Chinese economy is crashing and the Chinese stock market along with it.

Now that the rest of the world knows about the dire condition of the Chinese economy, the renminbi is under outright assault by those who hold it and want to get rid of it before its economic value falls any further. Somewhat the same is true of many other emerging world markets, especially those countries that exported raw materials and other products to satisfy the once ravenous appetite of the Chinese economy. One asset most of them have that might help them weather this storm is almost 15 years of  U.S. dollar accumulations by their central banks, mostly in the form of U.S. government debt instruments, as can be seen in the chart below taken from econbrowser.com. The majority of these funds are held by China, Japan, Saudi Arabia, and Switzerland.

To defend their currencies and obtain scarce capital, countries in economic distress are dumping American debt in the biggest such sell-off in fifteen years. See the posts “Quantitative Tightening” Worsening as Forex Reserves Drain Fast ,  China is dumping U.S. debt ,  Welcome to Quantitative Tightening as $12 Trillion Reserves Fall and Brace for QT, quantitative tightening, as China leads FX reserves purge.

The use of the phrase Quantitative Tightening (QT) in several of these post titles should be highly suggestive to you, given the amount of discussion about Quantitative Easing (QE) we have had in these pages. Indeed QT is supposed to suggest the exact opposite of QE. Just as QE is a program for lowering long-term interest rates by buying long-term debt to take it off of the market and make it more expensive, so QT is a process whereby long-term debt is sold into the market, decreasing its price by having more of it on the market, and thereby increasing its yield. Deutsche Bank appears to have been the first financial organization to point out these implications of the dumping of U.S. debt on the international market.

A number of attempts have been made to suggest that all this is not really a problem for the U.S. (see Debunking quantitative tightening in one paragraph? ,  ‘Quantitative Tightening’ Is a Myth (But That Doesn’t Mean There Isn’t A Problem) , and The Myth of Quantitative Tightening.) One objection is that China and other sellers of U.S. debt might just turn around and buy other debt instruments of similar maturity. Since the motive for selling U.S. debt was not to hurt the U.S. but to bolster their own currencies and meet some urgent economic needs in their own countries, it is hard to see the motivation for doing this. They need that capital at work in their own countries right now. Another argument is that because of monetary exchange effects, the bolstering of the yuan by China necessarily pushes the U.S. dollar down, which should be considered QE of a sort. The answer to that is that all of this is not about the international value of the dollar, but about the value of long-term interest rates. It is very hard to see how making long-term U.S. debt more available on the markets does not drive its price downward, thereby increasing its yield and long-term interest rates.

Whatever the dumping of long-term U.S. debt on the markets means for long-term interest rates, it is absolutely certain the U.S. will find far fewer eager buyers for U.S debt.  Consider the following chart from The biggest American debt selloff in 15 years.

With a sudden new need for capital, these countries would not seem to be in a position to buy any more U.S. debt anytime in the near future. If this is true, how would the U.S. government find anyone else to take up the slack? If they can find no one, will the Federal Reserve be forced into a new QE4 program just to ensure the federal government’s ability to get their new debt financed? What happens then with an untold number of future years of zero real interest rates? How can we possibly avoid this economic catastrophe in the making?

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