Wednesday, April 4, 2012

The Artificial Market for United States Treasuries

I stumbled across this very interesting presentation/speech while surfing the internet.  The presentation, entitled "The Sovereign Crisis: When Debt is No Longer Risk Free", was written by Lawrence Goodman, President of the Center For Financial Stability.  The most interesting section of the presentation was Mr. Goodman's examination of the role of United States Treasury debt in the current and seemingly endless global debt crisis.

Mr. Goodman notes that the role of the United States dollar as the world's first choice for its reserve currency is changing.  As I posted here, China is the world's largest holder of United States Treasury securities, holding a total of $1.1595 trillion worth at the end of January 2012 according to the U.S. Treasury Department.  This is definitely a massive holding, however, it is down from its peak of $1.3149 trillion just 7 months earlier, a drop of $155.4 billion or 11.8 percent.  In fact, Japan who was the largest holder of U.S. Treasuries until September 2008, now holds $1.079 trillion worth of Treasuries, just $80.5 billion less than China, down substantially from a difference of $425.4 billion in June 2011.  Looking on a year-over-year basis, China's holdings of Treasuries have remained more or less stable with a minute increase of only $4.8 billion (0.4 percent) in the entire year, a growth level that is a far cry smaller than previous years as shown here:

Mr. Goodman notes that the worldwide appetite for U.S. Treasuries is weakening and, that as this demand weakens, it will make it increasingly difficult for the federal government to fund its seemingly endless deficits.  This graph shows how the cumulative deficits as a percentage of GDP incurred by the federal government during the period from 2008 to 2011, as a response to the Great Recession, grew at a rate that was far higher than the recession in 1982 or even the Great Depression:

Within a three year period, the cumulative deficit in response to the Great Recession in the period from 2008 to 2011 reached 35 percent of GDP.  It took nearly 9 years for the cumulative deficit to reach 35 percent of GDP in response to the 1982 Recession and 10 years for the cumulative deficit to reach 30 percent of GDP in response to the Great Depression.  This data tells us that Washington is spending far more money in a far shorter period of time; money that they don't have, requiring the amassing of even greater debt and requiring the co-operation of the world’s bond purchasers.

Washington has grown most accustomed to having the world's bond markets swallow whole every bit of debt that they issue, largely because the world has regarded the United States dollar as its reserve currency.  This has allowed the United States to amass levels of debt (currently $15.620 trillion) that would be unserviceable by most other nations, save Japan, a country whose citizens own most of its debt, unlike the United States.

Here is a graph showing the amount of the United States debt maturing in the next year as a percentage of GDP:

You can quite quickly see that the rollover of maturing debt is just below its all-time high reached just after the Great Recession and is well above the 1973 to 2007 average of just under 10 percent of GDP. While the amount of debt maturing is not critical at this juncture, this is one of the problems facing the world's third largest nominal debtor nation, Italy.  In 2012 alone, Italy has nearly €340 billion worth of its debt maturing, nearly the size of the entire Greek debt problem.  Countries become vulnerable to their debt issues at maturity because re-funding the debt leaves governments at the mercy of whatever interest rates are prevailing at the time of maturity.  This is very similar to the issue facing mortgage holders when their term is up and they have to roll-over their mortgage debt at a new and possibly higher interest rate.

The United States will be facing this problem over and over again in the coming years.  As shown in this graph, the government debt profile was far different in 1946 than it was in 2010:

Just after the Second World War, over 35 percent of the total federal debt had maturities longer than 10 years; by 2010, that had dropped to 10 percent.  In 1946, approximately 10 percent of the total federal debt had maturities of between one and five years; by 2010, that had risen to nearly 40 percent of the total.  The current maturity profile is very risky because it makes the government very, very susceptible to a period of higher interest rates; it is best compared to a saver who, rather than laddering their fixed income profile, chooses to have most of them mature over a very short time frame.  In both cases, the risk is greatly elevated.

As I noted at the beginning of this posting, conventional wisdom has us believing that the demand for United States Treasury obligations will be endless.  Such is not the case as we saw in the example of the changes in China's purchasing habits.  This graph shows the drop in both private (red line) and foreign (green line) demand for United States Treasury Bonds since 2011:

Offsetting the drop in demand by private and foreign entities is, drum roll please, everybody's friend, the Federal Reserve as shown on the blue line.  This is, in large part, why the Federal Reserve’s balance sheet has done this:

Our pals at the Fed are single-handedly controlling the Treasury Bond market.  The actions (QE 1 and 2 and "The Twist") by the Fed are highly distortionary, pushing bond prices to artificial highs and yields to artificial lows as shown on this graph of 10 year Treasury Bonds:

The rather desperate steps taken by the Federal Reserve to stimulate the American economy back to life have resulted in an artificial market for United States federal debt.  Rather than reflecting the reality and risks of an ever-growing $15.6 trillion debt, bond markets are reflecting the seemingly endless purchases of Treasuries by the Federal Reserve.  This has prevented market forces from taking hold, lulling Washington into a false sense of debt security.  As I've posted previously, the average interest rates on the federal debt were at an all-time low of 2.306 percent in 2011, well below their peak of 6.639 percent in 2000 and their 12 year average of 4.539 percent as shown on this chart:

Not only should we be thanking Mr. Bernanke for missing the housing crisis and dumping record amounts of "cash" into the economy, eventually, we may owe him a debt of gratitude for lulling Washington into inaction on the pending federal debt crisis.  Way to go Mr. B.  You did it again!


  1. My question regarding your analysis (which is detailed, as always!) is: Can one say that holding American debt has become a bad idea b/c of the US government's moronic policies OR b/c nations just don't find it as good of an investment due to other pressing needs? Regarding the PRC, perhaps their growth is beginning to falter or they want to invest more of their money into their own economy? While I don't claim to know the answer, I was wondering what your thought process is.

    1. APJ:
      I believe I read yesterday that the majority of Treasuries purchased (either through rollover or new debt being issued) was done by the Fed.
      In my opinion, if true, this is a very discouraging sign.
      The market seems to be demanding higher interest rates, yet we continue to increase funding our debt, internally, at very low rates.
      When the Fed purchases debt, does this increase intragovernmental debt, or debt held by the public?
      Or, miraculously, is it a "wash," say a liability to the Fed, but an asset for the Treasury?
      Don Levit

  2. I had read that in the past few months, the Fed had purchased over 60 percent of newly issued Treasuries. From what I have deduced, nations are investing more of their reserves denominated in other currencies, particularly the CAD among others.

    I think that the debt owned by the Fed is treated as any other Federal debt (i.e. it is added to the debt owed by the public) and is treated as an asset by the Fed (i.e. it appears on their balance sheet)

  3. one shouldnt think of a "market" for US treasuries, or a demand for them in the normal sense...the shadow banking system uses treasuries in the same sense that you use a ten dollar bill in your wallet…there is actually a shortage of US Treasuries & other safe assets in the world's reserve currencies which is having a worldwide contractionary effect; i attempt to explain it in the last 2 paragraphs here, as well as i understand it, with embedded links to those who've pointed me to the realization...

    1. rjs:
      In your article, you wrote:
      A million dollar Treasury bill is used as money by the international banking system and by sovereign wealth funds in the same sense that you use a ten dollar bill in your wallet.

      Bruce Webb at the Angry Bear blog believes that Treasuries are more valuable than cash, because Treasuries pay interest.
      Do you agree?
      As you know, Medicare Part D is funded 75% by general revenues and 25% by participants.
      The general revenues are an expense, with an immediate budget impact.
      Do you believe in the Trust Fund Perspective - that is, that Part D is fully funded?
      Don Levit

  4. Don, on out dated treasuries, you could say they're more valuable than cash, but only to the extent that they pay more interest than inflation (not many do)...when i equated the use of treasuries by the shadow banking system with money, i was thinking in shorter term situations as they would be used as collateral in repo-agreements...

    i dont know enough about the funding for Medicare Part D to comment intelligently about it anymore than parroting the CBO...assume the trust fund is similar to social security's, which is good till 34 or 37 by various estimates:
    (that accounts for 2.86 trillion of your treasuries right there)

    1. rjs:
      When you say the SS trust fund is good until 34 or 37, you seem to be implying that there are no financial repercussions until then.
      If so, Stephen Goss, the chief actuary, recently made a similar statement
      But, this is not true.
      Now that the cash outgo exceeds trhe cash income, Treasury interest from the trust fund must be redeeemed.
      When that happens, new general revenues are needed AS IF THE TRUST FUND DID NOT EXIST!
      The same financial dynamics will ensue when the trust fund is depleted - new general revenues must be raised.
      The table you provided is the list of special security Treasuries, to be used exclusiovely for Social Security beneficiaries.
      However, the principal and interest of these Treasuries, the 2.86 trillion, was spent by the Treasury over the years to pay real expenses and lower real deficits.
      What remains of these "special" Treasuries is merely a hollow artifact, stripped of its store of wealth over the years to make the budgets look better than they really were.
      Don Levit

  5. so $2.86 trillion in treasuries has no value?

    china is going to be upset...& you better tell the Fed that those bank stress tests they ran are no good; the tier one capital the banks hold in Treasuries are merely a hollow artifacts, stripped of their store of wealth over the years...

    what did you expect the SSA to do with funds it had accumlated over the years, put them under the mattress?

  6. rjs:
    I expected the SSA to keep the principal and interest intact, to be used exclusively for Social Security beneficiaries, not use the proceeds to pay other expenses.
    If they are unable to do that, then the program was flawed from the start.
    Roosevelt wanted the system to be self-supporting, with no use of general revenues.
    What is happening with the hollowed Treasuries - they are redeemed with general revenues AS IF THE TRUST FUND DID NOT EXIST!
    China and other debt held by the public is an explicit liability - the strongest of 4 obligations to fulfill.
    Future Social Security benefits are an implicit promise - the lowest level of 4 obligations for the government to fulfill.
    According to the FASAB, the accoungting advisor for the federal government, Social Security is no different from any other welfare program, including those which require explicit annual appropriations.
    Don Levit

  7. well, don, if you should happen on any of those hollowed out Treasury notes, you can just pass them on to me...

    1. rjs:
      I am not saying they are worthless. I am saying they get their value from new general revenues, just like Medicaid gets its value from new general revenues.
      Don Levit

  8. so how is that different than if all the boomers had accumulated $2.86 trillion of Treasuries in their personal 401-K plans?

    1. Good question.
      Those Treasuries would be part of debt held by the public, the highest of 4 obligations for the federal government to fulfill. They are explicit liabilities.
      The Treasuries in the Social Security trust fund are implicit promises, the lowest of 4 obligations for the federal government to fulfill.
      Maybe that's why those Treasuries principal and interest were loaned to the Treasury to pay for current expenses, rather than kept intact.
      Of course, the plan administrator cannot be sure those Treasuries have been left intact.
      To my understanding, for proper diversification, private plans invest small percentages of their overall portfolois in Treasuries. This is in contrast to the Social Security trust fund, which is 100% invested in these "special" Treasuries.
      Don Levit

  9. so, i assume you're advocating programs to raise the minimum wage & to bring us back to full employment so that social security can be funded entirely out of revenues...

    1. How are we to return to "full employment?" I see it mentioned as the solution to our fiscal problems, but I haven't found the switch that turns on full employment. Please either explain or not rely on that prospect to solve our fiscal problems.

      I'm in agreement with what Don says about the SS trust fund. I discovered the truth only in the past year. Here's my explanation, from one layman to any other. (BTW, I'm not a wacko. I did my research at the SS website and St. Louis Fed.)

  10. ModeratePoli, although i'm not as well versed as i should be, i lean towards starting with a federal job guarantee, which has been widely discussed & promoted by MMT & minskyite economists; if you're not familiar with it, think in terms of FDR's CCC as a jump off point...once everyone's working, a virtuous cycle brings the private sector back in to respond to the increased demand & the federal program winds down...
    here's a recent post incorporating some of the thinking:

    bill mitchell is a proponent: as are most of the economists at UMKC, who blog at

    MMT isself was widely discussed after a recent artcle in the WaPo, some links are here:

    even conservative economists brad deong & larry summers have recently collaborated on a paper showing that under current conditions, expansionary fiscal policy would be self-financing; it was reviewed by economists at brookings & they agree with the math: here's a link: