The worst fears of some bond traders have come to pass, as news of China, traditionally the largest purchaser of U.S. debt, has been dumping Treasuries on the open market. Reports say that China has sold over $150 billion in Treasuries since this summer, but bond yields seem to be mostly unaffected.
Why is China selling Treasuries, and why is the effect much less than had been feared?
Why is China Selling Treasuries?
China has long been the largest foreign buying of Treasuries, holding nearly $1.4 trillion of U.S. debt. This is a bit over 1/3 of total Chines foreign reserves. Recent events mark the first time that China has been a seller of U.S. debt since 2001.
So, why are they selling now?
The short answer is that Beijing needs billions of dollars to finance their heavy-handed interventions in their domestic stock market and currency markets. It is estimated that the central government reserves have fallen by $200 billion due to these interventions. Chinese leaders used state-run media to urge ordinary citizens to invest in the stock market, resulting in a huge bubble. When the bubble burst, people felt misled by the central government, causing social unrest. Beijing went into panic mode, unleashing hundreds of billions of dollars worth of emergency measures.
On top of the stock market crash, the government loosened its control over foreign exchange rates, devaluing the yuan and letting it trade in a wider band. This was done in order to meet requirements for the yuan to be declared an international reserve currency, but the government quickly reneged on its promise to let market forces dictate exchange rates when the yuan began to plummet. The government order the central bank to intervene daily in the forex markets if the yuan fell too far.
All these emergency measures come at a price, especially when the economy is slowing. For a central government already worried about its exposure to U.S. debt, dumping Treasuries was a natural response to the need for immediate cash.
Who Else is Dumping Treasuries?
China is not the only traditional buyer of U.S. debt that is selling Treasuries to combat economic woes. Russia and Brazil are in tough economic straits, and Taiwan is seeing a marked slowdown in their economy. Nations dependent on oil revenue, such as Norway and Saudi Arabia have led their central banks to dump U.S. debt. This has led to a significant drop in foreign purchases of Treasuries.
Chart showing the huge drop in foreign buyers of U.S. debt.
Why Haven't Treasury Yields Increased?
With all these billions of dollars worth of Treasuries hitting the market, why are yields still so low? The biggest factor is an increase in domestic demand. U.S. mutual funds are gobbling up bonds at a record pace, which is partially offsetting China's absence from Treasury auctions. Another source of domestic demand is the requirements for "too big to fail" banks to hold higher capital margins in cash equivalents.
Despite the low yields, Treasuries are still offering better returns that any other "blue chip" government bond. This fuels foreign institutional demand.
Where Is the DOOM?
For years, pundits and politicians have warned that Chinese ownership of so much American debt could be wielded as a weapon to bring the U.S. to its knees. So, where is the Earth-shattering ka-boom that was expected?
One assumption of this doomsday scenario was that the U.S. budget deficit would continue to grow out of control. The reality is, the budget deficit has been cut by more than half since a high of $1.4 trillion in 2009. This is partly due to sequesters and the work of some Tea Party Republicans to reign in government spending. The annual deficit is now less than 3% of GDP.
If government spending isn't as far into the red each year, the Treasury Department doesn't have to issue as many bonds to finance the portion that taxes don't cover. As existing bonds mature, this causes the available pool of bonds to shrink even more. Since Treasuries pay more interest than German or Japanese sovereign debt, demand remains high. Demand is greater than supply, which means sellers (the government and private holders of Treasuries) don't have to offer higher yields to attract buyers. In fact, the government has recently been selling 3-month Treasury bills at zero percent interest!
These factors make this the perfect time for China to sell its Treasury holdings.
It's Not All Sunshine
This is the first year since 2012 that domestic demand for Treasuries has increased. However, there's a cloud in this silver lining. The sharp rise in demand is not only a chase for safe yield, it's signalling a consensus that the stock market, and the economy as a whole, are not in as good a shape as the government wants you to believe. The demand for 10-year and 30-year bonds shows that big investors do not expect inflation to hit the Fed's goal of 2% for years to come.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.