The Global Demand for U.S. Treasuries: Implications for Interest Rates and Economic Growth

As the Federal Reserve (Fed) proceeds with its Quantitative Tightening (QT) initiative, there are increasing inquiries about the Treasury Department's growing financing requirements. The aim of QT is to diminish the Fed's balance sheet, which has decreased to $7.7 trillion from $9 trillion, primarily through the purchase of Treasury notes during the economic turmoil triggered by the COVID-19 pandemic. Recently, households and, somewhat unexpectedly, international investors have been purchasing these securities. Given the significant volume of Treasuries being issued, both groups are expected to continue their purchases.

Recent Congressional Budget Office (CBO) data forecasts that the total public debt held by the Treasury will surge to more than $46 trillion by 2033. This anticipated rise in debt issuance is mainly due to increased government spending. According to the CBO, the U.S. government will face substantial deficits, ranging between 5% and 7% of the Gross Domestic Product (GDP) annually over the next decade. Therefore, to cover these deficits, the Treasury Department will have to issue a considerable amount of debt, seeking purchasers for it.

Currently, the Fed has stopped purchasing Treasury securities. Domestic entities like pension funds, mutual funds, retail and institutional portfolios, along with a variety of exchange traded funds, play a crucial role as buyers. Moreover, international investors continue to participate actively in Treasury auctions, although global central banks have reduced their presence compared to before.

With the national debt at $34.23 trillion and expected to rise, the success of U.S. Treasury auctions is vital for managing the interest costs. These auctions attract close attention from both the fixed income and equity markets, as the resulting yields can significantly impact the broader economy, with higher yields typically having a detrimental effect.

The Federal Reserve's Role as a Bond Purchaser During Economic Downturns

Historically, the Federal Reserve has intervened in the Treasury market in times of economic difficulty. This was notably evident during the Great Recession (2007–2009), which brought the concept of "Quantitative Easing" (QE) to the forefront. During this period, the Fed engaged in the purchase of substantial amounts of Treasury securities, an action referred to as large-scale asset purchases (LSAPs). From late 2007 to 2013, the Fed's balance sheet grew by $3.5 trillion as part of its efforts to strengthen the economy. By the recession's conclusion, the balance sheet had reached $4.5 trillion.

Federal Reserve Scales Back Holdings Post COVID-19 Acquisitions

Federal Reserve Ownership of U.S. Treasuries 2004-2024

The Federal Reserve's reliance on a variety of monetary tools has become a standard and formalized approach. However, a crucial element of these significant acquisitions is the Fed's current commitment to decreasing its balance sheet to levels seen before the crisis.

Between 1941 and 1951, the Fed maintained low interest rates to reduce the expense of the debt accumulated, continuing this policy for six years after World War II concluded. This strategy was similarly employed during World War I and its subsequent period.

Federal Reserve's Asset Holdings Expand Gradually in the Years Following World War II

Federal Reserve Ownership of U.S. Treasuries 1954-1974

Given the anticipated influx of Treasury debt expected to hit the market in the coming years, possibly extending into the next few decades, the Treasury Department will probably need to seek out additional buyers. The current demographic of Treasury purchasers is varied, including international investors and the Federal Reserve, which are among the largest holders of Treasury securities. However, the Fed, the principal holder of Treasuries, is in the process of reducing its substantial balance sheet, allowing $60 billion worth of Treasury securities to mature monthly without renewal, though it continues to reinvest in Treasuries any debt exceeding this cap. Presently, the Fed's holdings exceed $5 trillion in Treasury securities, accounting for about 25% of all issued Treasuries, but it aims to decrease its stake by several trillion dollars by the end of 2024. Although it's improbable for the Fed's balance sheet to revert to its pre-pandemic size, it's also unlikely to be a major purchaser of Treasury securities shortly, barring any unexpected macroeconomic events that might necessitate a return to quantitative easing. Consequently, the primary buyer of Treasuries might be stepping back for the time being.

International Central Banks as Key Purchasers

For many decades, the Federal Reserve was the primary central bank active in the Treasury market. However, in the early 2000s, global central banks started participating as well. Notably, the People's Bank of China (PBOC) began heavily buying at Treasury auctions in order to park its growing pool of export profits held in U.S. dollars. The scale of China's purchases drove 10-year Treasury yields lower, which led to a drop in mortgage rates. Some studies attributed the subsequent housing bubble in part to the decrease in rates stemming from China's Treasury buying spree.

By the end of 2006, foreign institutions held almost one-third of outstanding Treasuries, over twice the amount on the Fed's balance sheet. As more overseas buyers entered auctions, foreign holdings climbed to 40% just before the housing crash.

In the recession aftermath, many global central banks, especially in emerging markets, started unwinding their Treasury positions and actively selling. By 2015, the drop in foreign central bank holdings was 1.5 times what the Fed held, far below peak crisis-era levels.

China's central bank overtook Japan's as the largest buyer and holder of Treasuries, amassing over $1.3 trillion worth. However, as China moved away from dollar reliance and tensions with the U.S. grew, its stockpile leveled off at just under $800 billion.

Chinese Holdings of U.S. Treasuries Decline Further

Chinese Ownership of U.S. Treasuries

The Bank of Japan remains the top foreign holder of U.S. Treasuries. However, in recent years, its activity has declined as hedging expenditures have risen. There are worries that once the BOJ winds down its Yield Curve Control policy, which keeps 10-year Japanese bond yields within a target range, and hikes rates with deflation beaten, it may start steadily selling its Treasuries. The goal would be repatriating funds back home to Japan in order to benefit from higher yields. The dismantling of Yield Curve Control could be a precursor to such Treasury sales aimed at capitalizing on rising Japanese rates.

Japanese Purchasing Reverses After Steep Decline

Japanese Ownership of U.S. Treasuries

As geopolitical tensions rise and globalization retreats, many central banks like China's have turned to buying gold instead of Treasuries. Deterred by these concerns, buyers have shied away from participating in recent Treasury auctions. Global central banks are opting for gold purchases rather than Treasuries as cross-border political friction and deglobalization headwinds have made Treasuries less attractive to overseas institutions.

The Significance of Effective Treasury Auction Outcomes

With the Treasury's immense funding needs, auctions have become the mechanism for investors to help service America's ballooning debt. Fortunately, strong foreign demand buoyed the largest 10-year Treasury auction on February 7th for $42 billion, which settled at a lower-than-forecasted yield. Foreign participation was the strongest since February 2023.

With global central banks less involved, auctions now rely more on price-sensitive private buyers like households and mutual funds, both of which have been steadily upping their Treasury ownership. Historically minor buyers, their continued purchases are vital to absorb swelling Treasury issuance. And with higher yields not seen in over a decade amid mass baby boomer retirement, Treasuries should remain attractive to household portfolios needing income.

Unless fiscal spending is reined in, the ongoing ability to sell Treasuries at reasonable prices and yields has become the barometer for evaluating how well the U.S. economy and markets are working. The question is how long buyers, foreign and domestic, can support America with healthy yields before demanding better prices and higher rates.

There is also apprehension if auctions attract fewer buyers - who would purchase the excess Treasuries? The inevitable answer is always the Fed, the least palatable option for those wanting functioning Treasury markets. If auctions grow continually inefficient, it could be the inflection point that finally forces action on cutting the deficit.

Conclusion

Although there's significant focus on the upcoming surge in Treasury issuance, the main factor influencing Treasury yields remains Federal Reserve policy. I predict the Fed will manage to reduce the federal funds rate by 1%. Following a period where market expectations were excessively bullish, there has been a recalibration to align more closely with our projections. Consequently, unless there's a resurgence in inflationary pressures, Treasury yields might have reached their peak for this cycle. This scenario could bolster demand, especially if market forecasts anticipate lower yields in the coming year.

Additionally, this increase in Treasury supply coincides with slowing inflation and the anticipation of Fed rate cuts within the year. While investors may seek higher yields to absorb the larger volumes, the positive rate outlook for this year is expected to draw additional investment interest.

Given the current economic data indicating a more robust economy than initially forecasted, I believe Treasury yields will likely remain within a specific range in the short term. Despite debates over supply, it's plausible that the 10-year Treasury yield could hover between 3.75% and 4.25% throughout this year, with equal potential for both increases and decreases.