Is China Selling U.S. Treasuries?
There is much speculation that the Chinese central bank is selling off a portion of its holdings of U.S. Treasury debt. The People’s Bank of China (PBOC) currently has about $3.6 trillion in foreign government debt.
The PBOC recently reported that its holdings were reduced by $93.9 billion in the month of August. This has set off the rumors that the Chinese are selling U.S. Treasuries.
The only problem is that even if the PBOC is telling the true story, we don’t know for sure if its reduction in foreign holdings means a reduction in U.S. debt. Out of its $3.6 trillion of foreign reserves, about one-third of that is in U.S. Treasuries.
Therefore, it is quite possible that the Chinese central bank was selling off debt from other countries or regions. If the holdings were reduced proportionally, then “only” around $30 billion would have been from the U.S.
In many cases, it would not even be necessary to actually sell holdings. The Chinese central bank, or anyone else, could just not roll over maturing debt, which over time will reduce holdings. Holdings would be reduced faster if there were a higher proportion of short-term debt, as opposed to 10-year or 30-year bonds.
The U.S. Treasury issues a monthly report on major holders of U.S. debt, but there is a lag of about a month and a half. The last report shows China as the number one holder at $1.27 trillion for June 2015. This amount is about the same as it was exactly a year before that.
We will have to wait another six weeks or so before we find out China’s holdings for August according to the U.S. Treasury.
It is interesting that China would be reducing its foreign reserves given the events of the last few months. The big story last month was China’s devaluation of the yuan. But if China is trying to devalue the yuan, why would it be selling off U.S. debt? If anything, this would seem to indicate a tighter monetary policy.
The reason is likely that with the devaluation announcement, there was significant downward pressure on the yuan. So even though the PBOC was devaluing, it still had to sell off some foreign reserves to support the yuan from sliding too much.
Also, as the Chinese economy continues to deteriorate, it might make sense for Chinese officials to sell off some of the reserves. You could liken this to a family with a job loss or some unexpected expenses that decides to tap into some of its reserves.
The U.S. Consumer Subsidy
Chinese officials, while still officially communists, are really more mercantilist than anything. They believe in supporting the Chinese export sector by keeping down the value of its currency.
Since exporting is such a major part of the Chinese economy, they falsely believe in propping up the export industry. The problem is that this is done at the expense of Chinese consumers.
Meanwhile, it is a short-term benefit for U.S. consumers, who get to buy cheaper goods from overseas.
Unfortunately, it is also a subsidy to the Federal Reserve and the U.S. government. When China is buying up U.S. government debt, the Federal Reserve does not have to do as much to support low yields. It also means it is easier for Congress to run massive deficits with willing buyers of the debt at low rates.
The Chinese buying of U.S. debt has been particularly staggering over the last decade. If you go back to June 2005, Chinese holdings of U.S. Treasuries were around $300 billion.
While this buying spree has been a subsidy to American consumers, we can view it in a similar fashion as handing out welfare to an individual. The welfare helps the person in the short run, but it also creates dependency and can encourage more of the same behavior that is being subsidized.
Unfortunately, in the case of Chinese buying of U.S. debt, it encourages the U.S. Congress to continue its reckless spending, meaning that there is little serious discussion about balancing the budget and that when the subsidy dries up, it is going to be painful.
We have become accustomed to a low interest rate environment, particularly since 2008. It means cheap borrowing. It also means cheap borrowing for Congress. It goes on for so long, we start to think this is the way it will always be.
The Elephant in the Living Room
In July, Secretary of State John Kerry testified on Capitol Hill. He was attempting to defend Obama’s nuclear deal with Iran.
Kerry stated that if the U.S. does not cooperate on the world stage, it could be a recipe for the American dollar to lose its status as the world’s reserve currency.
In other words, Kerry inadvertently told the truth. He basically pointed out the financial elephant in the living room, which is that the U.S. relies on other countries to buy its debt and use its currency in trade.
Kerry again stated this argument at a news conference in August, indicating it was not just a slip of the tongue the first time.
But while Kerry is defending the Iran deal partially on financial grounds, it seems the media and Congress are paying little attention — or if they are, they want to quickly drop the subject.
There is a saying that if you owe the bank a hundred dollars, then you have a problem. If you owe the bank a million dollars, then the bank has a problem.
In this sense, China has a major problem in owning over $1.2 trillion in U.S. government debt, and that doesn’t count the other two-thirds of its holdings. The U.S. could stick it to the Chinese government hard. We shouldn’t expect an outright default, but nothing is out of the question if things get bad enough.
But even if interest rates were to significantly rise, and if the inflation rate of the U.S. dollar picked up, the Chinese could find themselves holding a bunch of bonds that are worth a lot less than what they paid.
Apparently this has not been a worry for Chinese officials, at least up until a month ago. If there were worry, then they wouldn’t have continued to accumulate U.S. Treasuries.
But the U.S. government should be worried, too. The statements by Kerry indicate that there may be some worry in the Obama administration. If China starts dumping U.S. debt, who is going to step in and buy it? If Congress has no plans to balance the budget, that leaves other investors and the Federal Reserve. If they turn to the Fed, that will mean another round of so-called quantitative easing.
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Rates: Up or Down?
Interest rates in the U.S. are one of the hardest things to predict right now because there are so many variables.
If China really is selling significant amounts of U.S. debt, then this will mean higher rates, all else being equal.
If the U.S. economy goes into a recession, this will point to lower rates as investors seek safety in locking in rates, even if they are low.
If the Fed starts up another round of QE, then this will also point to lower rates in the short run, as the Fed’s buying of bonds will tend to drive down yields.
On the other hand, if the Fed gets too carried away and we start to see rising price inflation, then this could end up leading to higher rates.
Right now, it is too early to tell with China. If China has sold off a significant amount of U.S. debt, it probably isn’t because Chinese officials abandoned their mercantilist outlook — they are just trying to temporarily support the yuan.
The threat to the dollar as the world’s reserve currency is real, as indicated by John Kerry, but it is not likely an immediate threat. It is something that will happen over time.
We can fully expect interest rates to go significantly higher one day. That is going to change the world we live in. It will be extremely painful at first, but in the long run, we will be better off for it, as Congress will be forced to cut spending. The Fed cannot sustainably buy all of the U.S. Treasury debt forever.
An economic downturn seems more likely today than it did a couple of months ago. This may lead to more money creation by the Fed. Both of these scenarios are bullish for bonds in the short term. This will mean lower yields, if Chinese selling does not offset this.
There will be a time to short the bond market. It is still not that time yet.
Until next time,
Geoffrey Pike for Wealth Daily
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