Fiscal Dominance & The Overstimulated Superpower

With some strategists worrying about fiscal dominance, I asked my ChatGPT what is “fiscal dominance” :

Fiscal dominance is a concept in economic theory where government fiscal policy, specifically the government's borrowing and spending decisions, effectively dictates monetary policy decisions. This scenario often arises when a government has high levels of debt, leading the central bank to prioritize the financing of the government's deficit over its traditional objectives, such as controlling inflation.

Under fiscal dominance, a central bank may be pressured to keep interest rates low or engage in extensive money printing to help the government finance its debts at sustainable costs. This can occur even if such actions are not in line with what would be considered sound monetary policy aimed at maintaining price stability or other macroeconomic goals.

This situation can lead to negative outcomes, including higher inflation if the money supply increases excessively. It represents a conflict or reversal of roles where monetary policy becomes subservient to fiscal policy, rather than being primarily focused on controlling inflation and managing economic growth.

So, in plain English, it is basically the concern that the government has difficulty financing itself and must resort to the lender of last resort, ie the central bank. I thought I would try to get my hands around US Treasury (UST) ownership trends to see if buyers are fleeing, leaving the Fed captured to accommodate the debt levels.

Let’s start with foreign owners. Here one would think that they’ve been dumping UST en masse given the United States’ status as the overstimulated Superpower. That analysis would be partly correct and partly not. In the chart below, I plot the amount of UST owned by foreigners. I broke it out to aggregate and official (think central banks). Since 2021, total foreign ownership has increased by roughly $1 trillion while the official sector has shed roughly $500 billion (likely defending their weak currencies). So, net net, private foreign buyers have snapped up. $1.5 trillion in UST since 2021. No trouble selling paper here…

Drilling down on the largest foreign holders, we can see that despite defending the JPY, Japan’s holdings have only fallen by about $130 billion. The UK’s holdings have increased by over $500 billion since Brexit. China, for probably obvious reasons, has consistently reduced their exposure over the last decade by about $425 billion. Ok, so China likely is not a viable future source of UST demand.

Let’s move on to the domestic sectors. Looking at the Flow of Funds, the increase in UST holdings by the household sector has surged by close to $2 trillion in the last couple years. Demand here seems insatiable.

Next, let’s look at commercial banks. As Silicon Valley Bank highlighted last year, some banks made some poor risk management decisions. Did banks dump their UST? A few, but for the most past they simply recategorized them as held to maturity so they didn’t have to mark to market. Even with the huge unrealized losses on UST, banks have only let go of a bit more than $500 billion, but since December they have increased their holdings by $170 billion.

Taking all this into consideration, it appears that private demand for UST has been huge the last few years. With this massive buying, the concerns over fiscal dominance forcing the Fed to buy UST just doesn’t seem like a thing right now. Not only is the Fed not having to buy UST—the single most identifiable symptom of fiscal dominance—they are letting them run off their balance sheet.

Fiscal dominance may be a problem, but as Captain Pete Mitchell (Tom Cruise) says in Top Gun II: Maverick in response to the claim that human pilots are no longer relevant “maybe so, but not today sir”.

This information is educational in nature and does not constitute investment advice. These views are subject to change at any time based on market and other conditions and no forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of any investment or trading intent. This content should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security.