Holy Cow! What is happening here? As readers can see in the accompanying chart depicting the one-year change in Central Bank holdings of US Treasury debt, foreign Central Banks have turned major sellers over the past year. In the latest release by the Treasury (September 30), the numbers show that the two biggest holders of US Treasuries, Japan and China, have sold $118 billion of Treasury notes and bonds in September, their largest combined monthly dump on record,
As of September 30, Japan owned $1 trillion, 120.2 billion of US Treasuries. That is indeed a very large amount, but it is also a reduction of $179.4 Billion from one year ago. In percentage terms, Japan has reduced its ownership of US debt by 13.8% from year ago levels and by a stunning 9.2% in the last two months.
Why would one of our biggest allies sell our debt? (The US has 55,000 troops in Japan the – larges forward deployed force anywhere in the world). Have the Japanese lost faith in the United States? We don’t think so. It is more likely they are using the dollar proceeds from their sale so they can purchase and defend their own currency. It’s a fact that the Japanese yen has lost approximately 32% of its value against the dollar since the beginning of 2021 (as measured to its low this October). The Japanese import close to 100% of their oil to power their industrial economy, so when you consider that they purchase their crude oil imports in dollars, you can just imagine the inflationary impact of their lower yen value. Indeed, the yen has rallied close to 8% since its October 21 low, so it is probably not a coincidence that the rally occurred soon after their late September sale of Treasuries.
It's a different story with the Chinese. At $933.6 billion, China is the second largest holder, but that number is down 10.9% from one year ago. Actually, we are quite surprised that the Chinese have not reduced their ownership of US debt at a much faster pace. They have seen how we have sanctioned Russia and seized Russian assets, so you would think that if they had decided to invade Taiwan in the near future, they would rush to reduce any US holdings. Perhaps President Biden is correct in his conclusion he made after his recent visit with Xi when he said that “I do not believe that there’s any imminent attempt on the part of China to invade Taiwan.” We also note that investors seemed relieved. Taiwan Semi-Conductor (TSM) has rallied an astounding 36% from its low made three weeks ago on November 3.
In any event, are these sales by the two largest holders of US debt a big problem? It could be, if these sales existed in a vacuum. Some market observers have opined that liquidity problems are beginning to emerge in the US Treasury market, and the law of supply and demand would imply that reduced purchases would lead to lower prices and a higher interest rate level, and that could, in turn, hurt stock market valuations.
However, the sales by Japan and China do not exist in a vacuum, and they do not significantly matter in the short run. The total amount of US Treasuries held by all Central Banks is $7 Trillion, 296.9 Billion. That is only down by $274 Billion from one year ago, or 3.6%. However, the really big problems are just starting, and will increasingly race towards us in the future.
First of all, on May 4, 2022, the Federal Reserve announced that it would embark on Quantitative Tightening. The Fed has been a big buyer of Treasury debt, but it has now reversed course, stating that it would permit about $1 Trillion worth of securities to mature without reinvestment within the next year. So if you combine this large reduction of purchases by the Federal Reserve with further reduction of purchases by foreign Central Banks, you do get a significant decline in demand.
At the same time, the Congressional Budget Office (CBO) has estimated and projected that there will be a cumulative fiscal deficit for 2022-2031 of $12.1 trillion, or an average of $1.2 Trillion a year. This increase in supply of the debt, which is occurring at the same time as a reduction in demand, should lead to lower Treasury pricing and a higher interest rate level – that is unless another big buyer steps into the breach. Who could that be?
If you look at the past, the answer is the Government itself. Intragovernmental holdings totaled more than $6.82 trillion in October 2022, an amount that is on a level owned by foreign Central Banks. These prominent governmental buyers are the Social Security trusts, including the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds; the Military Retirement Fund; the Office of Personnel Management Retirement; Medicare (which includes the Federal Supplementary Medical Insurance Trust Fund); and cash on hand to fund federal government operations.
The longer-term problem here is that the big trust funds are starting to run out of money. In the past, agencies like the Social Security Trust Fund, have taken in more revenue from taxes than they need. These agencies then invested in U.S. Treasurys. Unfortunately, this past will not be repeated in the future. As we stated in a previous post, the trustees for Social Security have indicated in their latest report that its trust fund will completely exhaust its asset reserves by 2034. Medicare is even in worse shape, and by 2026 Medicare Part A will not be able to pay for all of the costs it overs today.
Here's the rub: Unless Congress and the President start to work together to significantly reduce entitlement spending and/or significantly raise taxes, the Federal government will increasingly not have enough money to continue to be a major buyer of US Treasuries.
In today’s bitterly divided political landscape, we don’t think there is a “snowball’s chance in hell” that Democrats and Republicans will hold hands, sing Kumbaya and work together to reduce entitlement spending and/or meaningfully raise taxes. They can and probably will kick the can for a while and postpone a fiscal reckoning. Democrats will want to raise taxes so they can continue social spending, but increased taxation will tend to reduce consumer spending, which accounts for two-thirds of GDP, while Republicans will fight any tax increases. We are more than a little pessimistic, and we predict that the Federal debt level will continue to grow unabated. This will eventually force the Federal Reserve to become much more accommodative, and when they pivot and start to buy more Treasuries again, it will ultimately result in a worse inflationary environment than exists right now. When that happens, the US dollar will lose value, and that will, in turn, worsen the inflationary environment.
How soon will all this happen? The recent sharp rally in the S&P 500 implies that this reckoning is not close at hand. Be careful with your investments. There should be lots of volatility ahead.
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