US Debt and Foreign Creditors: Wall Street Journal

The Wall Street Journal: A steady decline in demand for U.S. government bonds from foreign investors hasn’t been the disaster many analysts and investors feared it would be.

Foreign ownership of U.S. government debt has been decreasing since it reached a peak of about 55% during the financial crisis in 2008, falling below 40% in November for the first time since 2003, according to the most recent Treasury data.

That marks a striking reversal from the substantial accumulation of U.S. debt by foreign investors during the 2000s, when the government swung from surpluses to record deficits tied to tax cuts and increased spending on the wars in Iraq and Afghanistan and, later, the financial crisis.

China, the largest foreign creditor to the U.S., owned as much as 14% of all outstanding Treasury debt in 2011. Today the country owns a little more than 7% of U.S. debt.

Deficit hawks have suggested government bond yields could jump if foreign investors shed their holdings of U.S. debt, which in turn could push up the cost of other debt throughout the economy, such as mortgages and business loans. Those warnings haven’t come to pass. “The fears of the past were exaggerated,” said Tony Rodriguez, who oversees taxable fixed-income investing at Nuveen. Mr. Rodriguez said he expects domestic investors to continue to buy a larger share of the government’s debt, a shift he said isn’t problematic at its current pace.

The Treasury Department sells debt in exchange for cash, which it uses to finance government operations. Rising deficits caused it to ramp up government borrowing last year following the $1.5 trillion tax cut and a deal to boost government spending by $300 billion over two years. Another factor boosting the size of Treasury auctions: the Federal Reserve is shrinking its portfolio of government and mortgage bonds, which it purchased to try to stimulate the economy following the crisis. That is forcing the Treasury to sell more securities to private investors. Last year, it increased its auctions of notes and bonds by about $335 billion, to $2.36 trillion from $2.03 trillion. Foreign investors absorbed a fraction of that increase, boosting purchases by just $13 billion in 2018.

Gennadiy Goldberg, an interest-rates strategist at TD Securities, points to a couple of factors. First, dollar reserves in China have fallen since 2014, meaning less demand for U.S. Treasurys. Second, the cost of hedging against a decline in the U.S. dollar has risen, making it more expensive to hold dollar assets. The shift shouldn’t provoke fears that bond yields, which rise when prices fall, will “head to the moon,” said Jon Hill, a government debt strategist at BMO Capital Markets. “As certain investors step back, other investors are willing to step in and buy.”

Domestic institutions and individuals have been filling the void. U.S. households increased their holdings of Treasury securities from $1.4 trillion in early 2017 to $2.3 trillion at the end of the third quarter of 2018, according to the Federal Reserve. China’s holdings of $1.1 trillion are less than the holdings of U.S. money-market funds and mutual funds combined. That has helped to keep a lid on interest rates. The benchmark 10-year yield has risen to about 2.7% from roughly 2.4% at the end of 2017.

Some analysts argue that while U.S. investors have bought more Treasury debt, those purchases have come at the expense of more growth-oriented securities, such as stocks or company debt. Those concerns mirror the debate surrounding the Fed’s balance sheet plans. Should this trend persist over time, some analysts are concerned that the U.S. could face difficulties trying to fund itself.

The Congressional Budget Office last week estimated annual federal deficits will exceed $1 trillion starting 2022, and will average 4.4% of gross domestic product over the next decade – well above the 2.9% average of the previous 50 years. Overall, CBO said it expects the U.S. to borrow $13 trillion over the coming decade.

Those projections don’t account for the possibility of a recession during that time, or that Congress will extend the tax cuts or boost federal spending again – factors that would likely necessitate higher borrowing.

The Treasury Borrowing Advisory Committee, a group of 16 finance and investing executives from firms such as Goldman Sachs Group, Vanguard Group and BlackRock, warned last week that the government could face “a significant financing gap over the next 10 years” and may need domestic investors to buy more government debt if foreign reserves continue to grow at a slower pace.

The dollar’s share of global currency reserves slipped to 62% at the end of the third quarter from more than 63% in the year-before period. Gains in the dollar also made U.S. Treasurys less attractive to foreign investors as the cost to hedge against the risk of a decline in the currency reduced the net interest of the securities.

Following a request from the Treasury, the advisory committee discussed a range of potential tools at a meeting last week that could help boost demand for government debt over the next decade, including additional floating rate notes, nominal coupon maturities and securities tied to inflation. The committee suggested one product in particular – a floating-rate note linked to the Fed’s secured overnight financing rate – deserved further study.

Brian Smith, the Treasury’s deputy assistant secretary for federal finance, told reporters at a briefing last week the ideas “are a brainstorming session, rather than a reflection of uncertainty.”

“It’s still very early days,” he added.

Daniel Kruger reports on bonds and currencies for The Wall Street Journal in New York.  Kate Davidson covers the Federal Reserve and U.S. economy from the Wall Street Journal's Washington bureau.

YG Correction: The chart initially assigned the wrong weight to the UK holdings in 2018. YG regrets the error.