For the past 3 decades, growing US deficits have been financed by the US issuing debt and selling some of it to investors (with the remaining debt, held by the US government, being equivalent to "money printing").
A decent percentage of those investors are overseas, and in 2022
foreigners held $7.4T of the US's debt, or about 30.3% of the public debt. In particular, merchants and manufacturers in China needed to do something with the dollars received as a trade surplus, so they bought treasuries. In Japan, investors needed to escape negative interest rates, so they bought treasuries.
This status quo has persisted for decades, and interest rates fell even as the US deficit increased, due to ever-increasing demand for treasuries. However, two factors are now occurring which could reduce foreign demand for US debt and thereby prop up interest rates:
Causes:1) The US trade deficit with China is shrinking. In 2018 China sold the US $418.2B more than the US bought from China. By 2023, this trade deficit was down to $279.4B, a 33.2% reduction over 5 years. That means there was up to $138.8B less annual Chinese demand for US treasuries in 2023 than in 2018, when the
US federal deficit was $894.65B lower. Meanwhile, an economic slowdown in China is further reducing Chinese production and exports, raising the possibility they may need to start selling some of their $870B in treasuries for economic stimulus, to go on a war footing, or both. Meanwhile, the bipartisan consensus in the U.S. seems to be for more tariffs and trade restrictions, which will leave China with even fewer dollars to reinvest into US Treasuries.
2) Japan holds $1.08 trillion in US treasury debt and is the US's biggest creditor. A few days ago, the Japanese central bank
raised interest rates for the first time in 17 years. Short-term rates have risen out of negative territory for the first time since 2016. Japanese investors can now choose to earn about a 0.75% return on their own 10-year bonds, or to
take the risks of a carry trade of earn 4.19% on US 10-year bonds. If the spread between US and Japanese bonds continue to narrow, US treasuries could become less interesting to Japanese investors - the US's primary foreign funding source. Japan has had CPI inflation greater than 2% since early 2022. Their "lost decades" could finally be over and they could become a more normal economy with a lot less demand for US treasuries.
Consequences:So foreign appetite for US treasury debt is potentially going down at exactly the same time the federal deficit is going up, and as the need to roll over existing debt -
now at $102,869 per citizen - consumes more and more of GDP. Perhaps this is what led the
U.S. Congressional Budget Office to warn that a market and currency meltdown like the UK experienced 18 months ago could be coming to the U.S. sometime soon.
The first consequence would be for treasury yields to end up a lot higher than they were in the 20-teens, because fewer Chinese and Japanese investors will be demanding a larger and larger supply of treasuries. That could mean the Fed's rate cuts to the overnight rate do not translate to longer maturities, and the yield curve becomes uninverted and then steep in the coming years. As suppliers face higher financing costs and a lower optimal-leverage point, they will have to increase margins to maintain a profit, and so we could see stubbornly high inflation (greedflation if you prefer) despite the Fed's accommodating policies.
For example, if someone on a supply chain holds a thing in inventory that costs $30k, they must borrow $30k and pass on the interest expense to their buyers in the form of a markup - i.e. gross margin. If the price of the thing goes up to $35k a year later, they must borrow more and pass on a higher interest expense to customers. Plus, if the person on the supply chain wants to earn a consistent real margin, they have to increase the customer's price even more. So the customer's price increases at a faster pace than the wholesaler's, due to growth in the interest expense and an inflation adjustment to the margin. All this can happen without inflation expectations changing - it's just math.
This illustrates how high rates could be paradoxically pushing consumer prices up. It may be why we seem to have plateaued in recent months on inflation and longer-term yields. Without as many foreign buyers, treasury rates might reach an equilibrium between supply and demand higher than it was in earlier years - into the realm of significantly positive real rates like we have now. Interest rates and mortgages would not return to the lows of 2021 anytime soon. Inflation could stay stubbornly just above target for a long time. The world - specifically Japan and China - are different from the world that allowed such low rates and negative real returns to occur.
De-globalization could mean less liquidity
within markets. In a de-globalized world full of trade barriers, interest rates are higher and local monopolies/duopolies face less competition. It becomes harder to use financial instruments to transfer investment cash from places where it is received to productive investments or to send business to lower-cost producers. Dr. Joeri Schasfoort of the Money & Macro YouTube channel
succinctly summarizes these points, based on economic research.
In theory, de-globalization could lead to stagflationary outcomes in many previously free trade economies, like the U.S. Volatility could be primed to occur if, for example, China felt nothing was holding it back from invading Taiwan, and a key supply chain for companies like Apple and Nvidia suddenly snapped, with no possible backup plan. Imagine the prices people would pay for the last iPhones or computers they could buy for the next several years!
Seen in this light, stocks might be expensive at a
PE ratio of 28.5, mortgages might be at the best rates we'll see for a few years and real estate values could hold up, iBonds might become popular again, and any bank not already overburdened with toxic assets could have lucrative opportunities ahead of them to exploit positive yield curve spreads.
Of course, treasury supply/demand factors are only one set of factors for the broader economy. Economic growth and gridlock over tax rates could lead to a period of late-1990's-style falling deficits, or maybe demand for treasuries arises from new places like Indonesia or South Korea. Maybe on-shoring results in a spurt of investment, GDP growth, and rising tax revenues.
I'm interested in your thoughts after reading the links above? Big factor or nothingburger?
