As US debt piles up, what happens if faith in Treasuries is shaken?

The sell-off last year was the first sign of something amiss, raising concerns that US government bonds failed to behave like a safe-haven asset
As central banks start to diversify away from Treasuries and markets reassess their positions, the risk is that Treasury yields could soar, igniting inflation amid tottering debt

Anthony Rowley

Published: 3:00am, 11 Oct 2021

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Tina, an acronym for “there is no alternative”, has been a tenet of faith in US debt and equity markets for so long that continuance of the situation is taken for granted by most investors. But what if allegiance to Tina is faltering along with the inexorable rise in US government debt?

The US$14 trillion Treasuries market is the biggest of its kind in the world and by virtue of its size and liquidity is critical to the functioning of the global financial system. As such, it is assumed to be indispensable but this depends upon the financial integrity of the US as a sovereign borrower.

The Institute of International Finance (IIF) has noted that on recent occasions, US Treasuries have “stopped behaving like a safe haven asset”. This has been dismissed as a technicality, yet, the IIF said, “it is at least possible that something more serious may be under way”.

“The US in 2020 saw foreign outflows from Treasuries, which is notable because as a safe haven asset they should have seen inflows at a time of heightened risk aversion. Foreign inflows picked up this year but [they] are not reassuring for a purported safe haven asset.”

Markets appear to be reassessing the status of Treasury debt as US government borrowing continues to soar. Leading central banks including the People’s Bank of China and Bank of Russia have been diversifying their holdings of international reserves away from US Treasuries for some time, according to Hung Tran, a non-resident senior fellow at the Atlantic Council in Washington and a former chief economist and managing director at the IIF. This is a response to geopolitical considerations and it will continue for now, suggests Tran.

Such comments, even from an institution such as the IIF which speaks for some of the biggest financial institutions in the Western world, tend to be obscured by commentators eager to highlight the global financial crisis that China’s Evergrande problem is supposed to be heralding.

US debt markets are at the heart of the network of financial arteries that keep the global economy functioning. They play a central role, with Treasury interest rates providing the fundamental benchmark for the pricing of most financial assets.

The first sign of something being amiss came in March last year when yields in the market shot higher – meaning that Treasury bill prices were falling.

It took US$1.5 trillion in Federal Reserve emergency quantitative easing to stabilise the Treasury market and, as the IIF observed, the problem did not end there. Funds continued to flow out of the market last year, while funds flowed into other leading debt securities such as German bunds and Japanese government bonds.

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Flows into the US Treasury market have remained subdued ever since compared with other government bond markets. As the IIF noted, “because a change in how markets see Treasuries would have far-reaching consequences, the US macro picture deserves far greater consideration in the debate”.

The US Treasuries sell-off last year was put down to being mainly due to micro “plumbing” issues, but again, as the IIF said, the episode “has many things in common” with other financial crises such as “a large and unexpected shock” and “liquidity that evaporates when it is most needed”.

Markets have good cause to be concerned about the size of US government debt. As the New York-headquartered US Council on Foreign Relations observed in an October 1 report, the “US national debt is once again raising alarm bells”.

“The massive spending in response to the Covid-19 pandemic has taken the budget deficit to levels not seen since World War II. This expansion follows years of ballooning debt – totalling nearly US$17 trillion in 2019 – that will now be even more difficult to reduce,” the report said.

There are further problems in the prospects of US Treasuries, according to Tran. “So far, the reduction in foreign demand for [these] has been offset by increasing demand from domestic investors, specifically mutual funds, driven by Covid-19-induced domestic savings.”

The key question is “what will happen when US domestic savings decline back to long-term averages and the Fed tapers and stops buying Treasuries. If there is no alternative source of demand materialising, this would contribute to pushing US bond yields higher”.

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Japan is the biggest single foreign holder of US Treasuries with some US$1.28 trillion of them as of June 2020 and is assumed also to be the most stable holder, given Tokyo’s close security ties with Washington, and perhaps the same goes for Britain, which holds about US$450 billion worth of Treasuries.

But China’s holding of short-term Treasuries has surpassed the US$1 trillion mark. Current tensions between Beijing and Washington might suggest that China is not such a “loyal” holder – and there are any number of other holders which might have reason to sell.

It hardly needs saying how risky the implied threat of rising Treasury yields could be when inflation looks like a powder keg waiting to ignite and when global debt is at record highs. We must hope that “plumbing” adjustments continue to fix the US Treasury market, and that it has not sprung a dangerous and lasting leak.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs