Where are the bond market vigilantes?

The typical price of irresponsible fiscal policy is higher long-term interest rates.

U.S. fiscal policy has been, in my view, somewhat irresponsible, particularly given the lack of private savings in the US. Over the past four years, the US government has shifted from a small structural surplus to a structural deficit. And the long-term deficits also has gotten worse, at least if you make reasonable assumptions about spending growth and assume existing tax cuts are made permanent.

Long-term interest rates, though, remain quite low. In part, this is because short-term interest rates remain low. But that is not the entire reason.

Let me posit one other reason: long-term interest rates have remained low because the US has not (yet) had to market many bonds to private investors.

The overall number of Treasuries in the hands of "US" market participants fell substantially between 1996 and 2000 as the supply of "marketable" Treasuries fell (as a result of budget surpluses), and then stayed constant between 2000 and 2003 despite the large increase in the overall supply of treasuries. Why? Because the Federal Reserve is holding more Treasuries as a result of its monetary policy operations and because foreigners - as we all know well - bought a lot of Treasuries. There is good reason to believe that most foreign purchases of Treasuries are coming from foreign central banks (see below). Consequently, the overall stock of Treasuries in the hands of US investors (other than the Federal Reserve Board) probably mirrors the stock of Treasuries in private hands reasonably well.

Chart

Put differently, private US investors certainly held lots fewer Treasuries in 2003 than they did in 1996 -- and private investors worldwide probably did to -- despite the Bush Administration’s 2002 and 2003 fiscal deficits. We don’t have full data for 2004, but the broad story likely stayed the same -- at least until recently.

Let’s look more closely at what happened when the US started to run large deficits, i.e. in the 2002 and 2003, using a range of data sources, not just the Bond Market Association (BMA) data. Between the end of 2001 and the end of 2003, the total stock of marketable Treasury debt increased by $632 billion (BMA)

Foreign holdings (mostly official holdings - see below) increased by $488 billion. (TIC)

Japanese holdings increased by $234; China’s recorded holdings increased by $79 billion The Fed’s holdings increased by $115 billion (BMA)

Implicitly, the holdings of US market participants only had to increase by $32 billion

The US also issues "non-marketable debt," mostly to the Social Security trust fund. The stock of this debt increased by $388 billion (Bureau of Public Debt, using fiscal year data); the holdings of the social security trustees increased by $319 billion (Trustees report).

So if the bond market has been less than vigilant, the fault, in some sense, rests with the world’s central banks. They were the ones who financed the increase in the US debt stock at current rates. The Social Security trustees are price takers, not price setters.

Why does all this matter?

Two reasons:

1. After buying roughly $170 billion of Treasuries both in 03 and 04, the Japanese government - the Ministry of Finance (MOF) and its agent, the Bank of Japan -- is now out of the market. Even if emerging Asia sticks on the dollar-yuan standard and continues to accumulate $150-200 billion in reserves, the pace of global reserve accumulation is set to fall off.

2. Social security reform - whether on budget or off - will increase the supply of "marketable" treasuries. Taking 2% of the payroll tax and putting the funds into private accounts adds roughly $100 billion - and more down the line -- to the amount the government has to borrow in the market.

So "partial privatization of social security" will add to the supply of Treasuries, and unless Japan resumes its intervention -- or some other big players starts to intervene -- there is likely to be less foreign demand for marketable treasuries going forward. And even if Japan does intervene, it may not intervene on the scale it intervened in 2003 and early 2004, when if provided $170 billion in annual demand for "marketable" treasuries. That would be true even if emerging Asia continues to informally peg to the dollar.

Treasury markets are deep and liquid. But it still seems to me that more supply and -- barring a resumption of enormous Japanese intervention -- less official demand will eventually translate into higher rates. For the first time since surpluses turned to deficits, the stock of treasuries in private hands will need to grow rapidly as well. Convincing private investors to shift more of their savings into Treasuries likely will require higher rates.

Of course, if central banks started dumping some of their existing stock of Treasuries to diversify their reserve holdings(as the Russians apparently are doing), private investors would need to digest an even bigger increase in supply.

An aside. In 2003, we know central banks overall holdings of dollar reserves increased by $442 billion (@ $482 billion if you include the reserves China transferred to its state banks). Reported official holdings of Treasuries increased by $171, total foreign holdings increased by $290. Not all dollar reserves go into treasuries - some certainly are going into agency bonds and some are kept in deposit accounts. Some may be going into asset backed securities or even corporate bonds. But it also seems likely that the Treasury holdings of central banks increased by more than the reported $170 billion in 2003.

In 2004, official holdings have gone up by $183-184 billion (YTD), and foreign holdings by $326 billion (YTD). Take out Japan, though, and the increase looks less robust, relative to US demands for financing. Non-Japanese foreign holdings of treasuries increased by $158 billion (YTD) - a lot, but not enough to keep the stock of treasuries in private US hands from rising. That is relevant, because the US will need to fund a large deficit in 2005 and will experience a substantial drop in foreign demand for Treasuries if the Japanese don’t resume intervening in a big way.