Opinion
The $2.8 trillion question: America is hunting for cash, but there’s a bit of a problem
Stephen Bartholomeusz
Senior business columnistFitch Ratings’ downgrading of America’s credit ratings might have captured most of the headlines but there was another report this week that, while it fits with Fitch’s assessment of America’s finances, probably has more direct and material implications for US and global financial markets.
On Wednesday, the US Treasury department outlined its plans for bond sales in the September quarter. In May, it estimated raising a net $US733 billion ($1.1 trillion) through issues of Treasury debt securities. It now says it will raise about $US1 trillion, with $US103 billion of auctions scheduled next week.
The main driver of the need to raise the increased amounts of debt is the US budget deficit, which has been exploding and is expected to be just under $US1.4 trillion for the first nine months of this year.Credit: AP
Moreover, it expects to raise another $US852 billion in the December quarter. In a six-month period, the US will have raised about $1.85 trillion ($2.83 trillion), roughly the same amount of debt as it did in all of 2022.
The main driver of the need to raise the increased amounts of debt is the US budget deficit, which has been exploding and is expected to be just under $US1.4 trillion for the first nine months of this year – 170 per cent higher than at the same time last year, with the higher interest costs caused by the Federal Reserve’s efforts to fight inflation a significant factor.
Lower tax revenues, which might reflect some timing issues, have contributed to a weaker-than-expected revenue line, with revenues about $US260 billion lower than for the same period of 2022.
The other factor in the swollen borrowing requirement was the lengthy stand-off over the debt ceiling earlier this year, which forced Treasury to take “extraordinary” measures to keep the government functioning without breaching the $US31.4 trillion debt ceiling.
That forced Treasury to run down its cash reserve, which it is now trying to rebuild. It had only days of funding left when the debt ceiling was finally raised, but has built its reserves back to about $US550 billion and is targeting $US750 billion of cash by year-end. That has added to the scale of the program of debt issues.
Where the Fitch downgrade caused only ripples in the bond market, and is unlikely to have any material lasting effects, the scale of Treasury’s proposed securities sales is likely to have more meaningful impacts. That’s a lot of new debt for the market to absorb.
The obvious conclusion is that it will push up the yields on Treasury securities – bills, bonds and notes – that are already elevated because of the Fed’s 11 rate rises since March last year. The federal funds rate is at its highest level since 2001.
The US bond market is the world’s biggest and most liquid, and it will absorb the deluge of bonds in prospect – but there will be a price paid for that scale of supply. Bond prices will fall and yields will rise (there is an inverse relationship between the two) relative to where they might otherwise have been.
The obvious follow-on question is: who will be the buyers?
The most significant buyer of US government debt for much of this century has been the Fed, via several of its “quantitative easing” programs, or purchases of government securities and securitised mortgages. The most recent burst of quantitative easing was during the pandemic, with the Fed’s balance sheet more than doubling from about $US4 trillion to almost $US9 trillion in less than two years.
However, the Fed was engaged in quantitative tightening from June last year, in tandem with its rate rises. Its balance sheet was shrunk by allowing securities it holds to mature – without reinvesting the proceeds – at a rate of up to $US95 billion a month. Up to $US60 billion a month of that $US95 billion was Treasury securities.
Since May last year, the Fed’s balance sheet has shrunk from $US8.91 trillion to about $US8.24 trillion, with the run-off of the Fed’s holdings continuing and withdrawing liquidity even as the US Treasury is pumping it back in via its increased deficits and its debt issuance.
If the Fed is on the sidelines, other buyers will need to step up.
Japan and China are the two biggest sovereign holders of US government debt.
China has been steadily reducing its bond holdings in the past few years – from a peak above $US1 trillion to around $US860 billion – even though it has broadly maintained its exposure to US dollar-denominated assets.
Japan has around $US1 trillion of bond holdings, but Japanese-related investment in Treasuries is more likely to fall than rise.
The bond sale could be a threat to the sharemarket.Credit: AP
There have been signs that Japanese investors – and hedge funds employing carry trade strategies using cheap Japanese debt to invest in higher-yielding US debt – are starting to repatriate some of those funds.
With the very recent shift in the Bank of Japan’s monetary policy to allow yields on its bonds to rise slightly, the relative appeal of Japanese government debt has improved and the returns from the carry trades have been squeezed.
When the regional banking crisis developed in the US earlier this year, there was a big shift of deposits out of those banks into the big banks and money market funds. A lot of the funds’ cash is held in overnight repurchase agreements with the Fed.
That cash is seen as a likely source of buying for the flood of government securities from now until the end of the year. The higher yields may also attract bank deposits more directly and investors in other assets may cash them out to lock in the attractive, essentially risk-free returns from the bonds.
If the Fed is on the sidelines, other buyers will need to step up.
That could be a threat to the sharemarket, which has been on a big run since last October, and especially to some big tech companies trading on multiples of their future earnings that are difficult to rationalise in a rising interest rate environment. (The 10-year bond yield is the key input into calculations of the net present value of their future cash flows – as it rises, that net present value falls).
Despite Fitch’s move and the highly-charged, dysfunctional political environment in the US that it cited as a reason for its downgrade, higher yields will also attract a range of foreign investors to what is still regarded as the safest and most liquid market in the world.
There might be some institutions whose mandates don’t allow them to invest in anything less than AAA-rated securities, but that should have a limited effect on demand if the price is right.
The market will absorb the deluge of US government debt but there is potential, in a fragile global environment, for it to have flow-on effects for other markets, other corners of the financial system and for the US and other economies, particularly as the likelihood of continuing increases in the US deficit over the rest of the decade and beyond means that increased call on global savings won’t be a temporary phenomenon.
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