Tuesday, April 25, 2017

Will the Fed selling Treasuries affect interest rates?

On April 5, it was reported that the Federal Reserve wants to start unwinding the $4.5 trillion in bonds on its balance sheet this year. This revelation came from a summary of the Federal Open Market Committee meeting held in March. The composition of the Fed's balance sheet can be seen in the following chart:

Note: In the following charts, click on the chart to see its data and sources.

Federal Reserve balance sheet: 2003-2017

As can be seen from the purple area in the chart, about 2.5 of the 4.5 trillion in assets are Treasuries. Also visible is that these levels have remained stable since the end of 2014, when QE3 ended. In any event, there has been much discussion on what will happen when the Fed starts selling its Treasuries. More specifically, who will step in and buy the Treasuries that the Fed is selling plus any additional debt being created? To judge this, it helps to look at how the holders of Treasuries have changed over time. The following chart shows the holders of Treasury securities since 1970:

Major Holders of Treasury Securities: 1970-2016

As stated below the table on this page, this includes marketable and nonmarketable Treasury securities held by the public (net of premiums and discounts) and Treasury securities held by federal government employee retirement funds. Hence, it does not include the $2.8 trillion of special-issue treasuries held by the Social Security trust fund. In any event, it's worth noting how the total value of Treasuries has increased sharply since the financial crisis. Hence, there is likely to be a great deal of new Treasuries that need to be bought in addition to those being sold by the Fed.

The chart does show that the value of Treasuries held by individuals and mutual funds increased sharply after the 2008 financial crisis. It would seem likely that this was in response to the fact that Treasuries were one of the few asset classes that did not go down sharply during the crisis. The value of Treasuries held by banking institutions also increased somewhat, possibly due to the improvement in their balance sheets. Treasuries held by government (state and local) and insurance companies seemed to remain fairly stable. Pension funds (including government retirement funds) did increase somewhat but were already major holders of Treasuries. Of course, as shown in the first chart in this post, the value of Treasuries held by the Fed increased sharply starting in 2011.

The one other major holder of Treasuries were foreign holders and they likewise can be seen to have increased after the crisis. The composition of this group can be seen in the following chart:

Major Foreign Holders of Treasury Securities: 2000-2016

As can be seen, Japan and Mainland China are the two countries with the largest holdings of Treasuries at just over $1 trillion each. The chart shows that the holdings of both countries have decreased over the past three years. The next two largest holdings are in Ireland and the Cayman Islands. This may initially seem surprising but the reason is that both are regional financial centers. The holdings in both of those countries have increased sharply since the financial crisis. Finally, the olive-colored line shows that the holding of all other countries have remained about the same over the past two years. As a result, the blue line at the top shows that the holdings of all countries has decreased slightly over the past two years.

Judging from the above chart, it would not seem that foreign holders of Treasuries can be counted on to buy many of the new Treasuries being created or sold by the Fed. One exception would be if those Treasuries pay higher interest rates. Another exception might be if there is another global financial crisis and U.S. Treasuries are seen as a safe harbor. The same may be true for Treasuries bought by individuals and mutual funds. Higher interest rates and/or a major market correction could motivate more investors to buy Treasuries.

There is no agreement on the effect of all this on future interest rates. For example, one blog suggests that "[i]n addition to actual rate hikes, this would put further upward pressure on interest rates, and downward pressure on bond prices." However, another blog reminds readers that "[a]s the Fed ceased QE1 and all economists knew rates must rise...rates shocked 100% of economists and fell by a third." It concludes "I don't think the Federal Government nor the Federal Reserve are about to let a "so called free-market" determine the yields paid on America's debt." Of course, the Federal Government and Federal Reserve may not be able to do anything to avoid higher interest rates. However, it is true that higher interest rates will cause the interest payments to increase, putting additional pressure on the U.S. budget. This will certainly be a motivation to keep interest rates low if that is possible.

Friday, April 21, 2017

Why does President Trump like a low-interest rate policy?

In an interview with the Wall Street Journal published on Wednesday, April 12th, President Trump said "I do like a low-interest rate policy, I must be honest with you". This view has reportedly changed over time with Trump saying that "Janet Yellen should have raised the rates" on November 3, 2015. In any event, it seems worth looking into why Trump may be supportive of a low-interest rate policy now.

This blog post lists winners and losers from low interest rates in the United Kingdom. The third item listed under winners is government debt payments and the first chart shows that bond yields are declining but then states the following:

This fall in bond yields is occurring, despite a rise in government debt to GDP, and a persistent budget deficit. It is important for limiting the percentage of tax revenue spent on debt interest payments.

This same statement could be made about the United States. The following chart shows various treasury interest rates since the early 50s:

Note: In the following charts, click on the chart to see its data and sources.

Treasury Interest Rates: 1953-2017

As can be seen, they have been dropping since they reached highs in the early eighties. The following chart then shows the federal debt as a percentage of GDP:

Public and Gross Federal Debt: 1940-2021

The red line is the gross federal debt and includes the debt owed to Social Security and other government trust funds and the blue line is the federal debt owed to the public. The net interest that is paid on this debt to the public is the purple line in the following chart:

Top U.S. Federal Outlays: 1970-2012

As can be seen, the net interest has come down to historically low levels even as the federal debt has risen sharply. This is due to the historically low interest rates being paid on that debt. However, note that the net interest is projected to double from about 1.25 percent of GDP in 2015 to about 2.5 percent of GDP by 2021. This is chiefly because the interest rates being paid on that debt is projected to increase. The following table shows the projected rates that will be paid on 91-day Treasury bills and 10-year Treasury notes through 2026:

Table S–12. Economic Assumptions
(Calendar years)
                            Actual  Projections
                            ------  -----------------------------------------------------------
                              2014  2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026
Interest rates, percent:      ----  ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
  91-day Treasury bills  .....   *     *  0.7  1.8  2.6  3.1  3.3  3.4  3.4  3.3  3.3  3.2  3.2
  10-year Treasury notes ..... 2.5   2.1  2.9  3.5  3.9  4.1  4.2  4.2  4.2  4.2  4.2  4.2  4.2

* 0.05 percent or less.
Source: U.S. Budget, FY 2017, Summary Table S-12
The CBO (Congressional Budget Office) just put out The 2017 Long-Term Budget Outlook in March. On page 19, it states:

The government’s net interest costs are projected to nearly double as a share of the economy over the next decade—from 1.4 percent of GDP in 2017 to 2.7 percent by 2027—as currently low interest rates rise and as greater federal borrowing leads directly to greater debtservice costs. In the extended baseline, those costs reach 6.2 percent of GDP by 2047 (see Figure 5 on page 12).

It would seem very possible that President Trump has been made aware that lower interest rates would have a beneficial effect on the budget, making any planned tax cuts or infrastructure spending more affordable. That could have much to do with why he now likes a low-interest rate policy.

About Me

I became interested in U.S. budget and economic matters back in 1992, the first time that I remember the debt becoming a major issue in a presidential election. Along with this blog, I have a website on the subject at http://www.econdataus.com/budget.html. I have blogged further about my motivations for creating this blog and website at this link. Recently, I've been working on replicating studies such as the analysis at this link.

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