US Debt for Sale but at what Price?

May 22, 2017

A major worry hanging over the markets is who will be the next buyer of U.S. debt. Over the last several years the Fed has been the largest buyer of U.S. treasuries providing liquidity to the financial system known as “quantitative easing”.  In fact, last year the Fed financed 40% of our country’s deficit via purchases of U.S. treasury securities and holds an estimated $2.5 trillion of U.S. treasuries, and a further $1.8 trillion in mortgage backed securities. Investors must be constantly vigilant when a single player dominates a market. So who will replace the Fed’s buying power if it chooses to walk away?

Over recent years the Fed has been the dominant force in the market, but has not behaved as an economic buyer of bonds. The Fed really did not care about price. Instead its focus was on how its actions would stimulate the economy. We have been through what amounts to an extraordinary period of market manipulation even though the U.S. treasury market is the largest, and most liquid, market in the world.

In contrast, other buyers do care about the price and earned rate of interest. Real investors want yield and the prospect of an uncertain move back to normal conditions is what bothers the market. What level of interest rates will bring real money back into the treasury market?  If 40% of last year’s debt was purchased by a non-interest rate driven buyer like the Fed what interest rate will be needed to attracted investors as the Fed steps away?

In addition to the concern about who will replace the Fed as a buyer, the markets are also worried about the additional trillions of dollars in debt that might be needed for infrastructure needs. Moreover, there is a further $10 trillion in potential debt that might be needed for Social Security and Medicare. Finally, we should not forget that tax relief for corporations and individuals could also put additional demands on financing.

Uncertainty is generally not a good thing for a market. The outlook for the U.S. debt market over the next 24 months, in terms of volume and price, is a major concern. If inflation stays muted perhaps investors will be willing buyers of government debt at current levels. If the economy accelerates and inflation heats up, higher returns might be warranted.

Carl Gambrell