Who will buy our Treasury debt?

Andrii Dodonov

The Congressional Budget Office (CBO) recently reported the US budget deficit for the just-ended fiscal year 2022 was -$1.4 trillion. This is a significant step up from last year – $2.8 trillion, halving the 2021 deficit.

The improvement comes from an increase in revenue, especially income taxes, and a sharp drop in pandemic-related spending, such as stimulus checks and small business loans, which were designed to be temporary.

Nevertheless, this is the third year in a row that the deficit has exceeded $1 trillion. With interest rates rising due to 40-year highs in inflation and Fed tightening, this trend will continue for years to come.

As the Treasury prepares to raise new cash to fund the deficit, many of the biggest buyers of US government debt are moving away from investing in Treasuries.

Federal Reserve

The largest individual owner of Treasuries is the Federal Reserve. As of June 30e, Fed holdings peaked at $6 trillion. That same month, the Fed began its balance sheet liquidation with the implementation of quantitative tightening (QT) as part of its policy normalization program. Initially, they allowed $30 billion of Treasury securities to roll each month to maturity. In September, the plan was fully adopted and $60 billion is now allowed to flow each month.

Since 2008, when the Fed launched its quantitative easing (QE) program, the Fed has gobbled up Treasuries. Their share of ownership of the US Treasury market has fallen from 7.6% in 2008 to 26.0% currently.

% Largest holders of US government debt

Treasury International Capital System and Federal Reserve

Over the past two years during the pandemic, when the Fed reinstated QE and doubled the size of its balance sheet, the Fed bought 57% of all new Treasury issues (this was done in the secondary market, because the Fed does not buy primary market problems.)

Now though, as the Fed moves into a full-fledged QT, its nearly insatiable demand for Treasuries has disappeared. The impact on Treasury yields was noticeable.

The decline in Fed demand for Treasuries actually began with the release of the November 2021 FOMC minutes, when it was revealed that the Fed would begin to scale back its securities purchases, reducing its appetite by 10 billions of dollars per month. The 10-year T-note yielded 1.55% at the time.

As shown in yellow in the 10-year T-note chart below, since that date the yield has practically increased.

Over the past eleven months, the Fed has gone from phasing out its purchases to halting its purchases, slowly starting its balance sheet reduction and fully implementing its balance sheet reduction. As of Friday’s close, the yield on the 10-year T-note was above 4.0%, the highest level since 2008.

Yield on 10-year treasury bills

Bloomberg

Foreign holders

The Fed was not the only major holder of Treasuries to reduce its positions. The next two largest owners of Treasury bonds are China and Japan.

China was the second largest owner of Treasuries, and their holdings peaked at $1.3 trillion in 2013. Since then, their positions have gradually declined. This year, for the first time since 2009, their position fell below $1 trillion to $967 billion. China faced a slowing economy and reduced its treasury holdings to defend its currency.

Japan moved into second place as its Treasury positions gradually increased to nearly $1.3 trillion.

The largest holders of US government debt

Treasury International Capital System and Federal Reserve

Although the absolute amounts of Chinese and Japanese Treasury holdings have fluctuated only moderately, as a percentage of total US debt outstanding, they have not kept pace with the growth of US government debt.

From peak holdings of 12.3% and 15.7% of total US debt, China and Japan’s shares have fallen sharply to hold just 5.2% and 4.0%, respectively. .

Other foreign holders of Treasury debt experienced the same relative decline.

In total, more than 40 countries hold US Treasury securities. From a peak of 48% in 2008, total foreign ownership of US debt has fallen to 31%.

% Foreign debt holders

Treasury International Capital System and Federal Reserve

American financial institutions

The last major segment of treasury bond buyers is that of US financial institutions. This group is made up of commercial banks, mutual funds, pension funds, state and local governments, and insurance companies. They are generally more rate sensitive than the Fed and foreign governments.

Collectively, US financial institutions constitute the largest of the three groups of buyers of Treasuries. As of June 30, 2022, they held $10.2 trillion in US Treasuries, a gain from $9.5 trillion at the end of 2021. Although in absolute terms, their market share of the US Treasury has remained relatively stable over the past 20 years and has hovered around 40%.

American financial institutions

Federal Reserve

With increased supply and reduced demand for Treasuries, for this group to fill the void, they may need to see more attractive yields. How high returns should go is an open question.

Liquidity

As the bond market sells off and two of the big three move away from Treasuries, a new problem is emerging. The Treasury market has always been the largest and most liquid segment of the bond market. Large amounts of securities are traded daily. Large trades generally have little impact on the bid-ask spread. This is called market depth.

However, recent activity has shown a worrying deterioration in market depth. As measured by the Bloomberg US Government Liquidity Index, seen below, liquidity is evaporating. This index measures, on average, how far returns are from what fair value models suggest they should be. The index has just passed the pandemic-induced peak of March 2020.

Government Liquidity Index

Bloomberg

As Treasury bond issuance increases to fund our deficits, a perfect storm is building from the combination of QT, big players pulling away from the Treasury market, rising yields and liquidity. scaled down. He will tell how we are navigating through this during the current period of global financial volatility.

The question remains “Who will buy our Treasury debt?”


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John A. Bogar