• Trumps plans are adding %1.5 Trillion to America’s debt burden
  • This is the cost of his tax cut programme and new infrastructure investment
  • Treasury yields have broken higher after months of decline
  • Is the given that foreign accounts will keep on buying a certainty?

There used to be an infallible rule of western politics. Parties on the left of centre were the high spending whereas those on the right of centre showed fiscal responsibility and restraint.

That seems to be a yardstick that is no longer valid as it appears that in the United States, the Republican Party or “Grand Old Party” (GOP) only care about the scale of the federal deficit when they need a reason to attack to legacy of past Democratic administrations.

President Trump plunged the US further into debt, (in the short-term only…if the economy keeps growing), to the tune of $1.5 Trillion in debt by slashing taxes on corporations and wealthy families in December.

However, Congress’s official estimators, The Joint Committee on Taxation, said that even with steady economic growth between 2.7% and 3.2% the Trump Tax legislation would add $1 Trillion to the debt level.

US National Debt 12-02-18


Source: US Treasury


There was another short-term shutdown of certain government activities last week which was ended when Republican leaders in Congress pushed through a two-year budget deal on Friday that will increase spending by nearly $400 Billion.

Much of that money will be spent on priorities such as disaster relief, infrastructure and education, however, a sizeable allocation will be directed to new military spending.

This action must be contrasted with the strategy of Republican lawmakers in 2011 when they refused to raise the federal debt limit until President Barack Obama agreed to deep cuts in spending.

Economic Management

Students of macroeconomics will appreciate that so called “deficit spending” is, on occasion an indispensable tool by which an ailing economy can be stimulated through targeted investment in productive infrastructure, rebuilding after natural disasters etc.

During the financial crisis it was an essential tool as many governments had to fill the void created by a loss of private sector confidence to prevent a recession becoming a depression.

Right now, however, when the U.S. economy is motoring along at a healthy clip and the economy is almost operation at full employment is even more stimulus required? I certainly favour lower taxation however, there does come a time one the very wealthy do have enough cf. the rest, especially the ever squeezed middle and maybe a choice should have been made between large tax cuts and large infrastructure spending. Maybe a little less of both would have been a better way ahead.

Why am I saying this?

In January, the 10-year U.S. Treasury spread of 2 and 10-Year broke out of a long descending channel with T2/10 at 72bps on the week to close on Friday.

Tsy and T2 T10 12-02-18

Source: US Treasury


If the 10-Year Treasury (T10), hits 3.0%, it will be interesting to find out if that will be taken by overseas accounts as opportunity to expend their holdings of US paper?

So far, overseas accounts have continued to acquire Treasury securities as at last November, they held $6.34 Trillion in Treasury paper, down slightly from October’s record $6.35 Trillion.

Normally when issuance has risen, so have foreign purchases, however, in March 2016, foreigners held $6.29 Trillion implying their holdings have essentially been flat for over 18-months. They have not been increasing purchases and it is certain that the Trump plans will require Treasury issuance to be trending higher in 2018.

This comes at a time when the Fed is slowly winding down its asset holdings. Back in September 2008, SOMA (system open market account) holdings stood at $473 Billion. This was followed by three separate programmes of quantitative easing so that by April 2017, SOMA holdings had ballooned to $4.24 Trillion.

  • As of January 31st, 2018, they stood at $4.18 Trillion, a decline of $59 Billion!

The Fed began curtailing its bulging balance sheet last October by $10 Billion/month through December, followed by acceleration in the pace every three months. By October 2018, the balance sheet would have been reduced by up to $50 billion/month (comprising both Treasuries and mortgage-backed securities). This means balance sheet reductions of $600 Billion a year.

New issues meet sloppy demand

Given that the United States has a dreadful record of dilapidated roads, bridges, railways and water systems need to be upgraded and repaired. The budget bill only partly addresses many of these and other needs. Therefore, new issuance is required.

The question is, will the issues be covered as efficiently as before? This week equities were under pressure from many directions, but one painful pressure point came the Treasury market where another weak auction put gave bond bears ammunition.

The Treasury Department auctioned $24 Billion in 10-year notes at a high yield of 2.811%. The Bid-to-Cover ratio, an indicator of demand, was 2.34 times.  This was down from 2.38 times in January. Indirect bidders, which include major central banks, were awarded 67.5%. Direct bidders, which includes domestic money managers, bought 5.4%.

When the Treasury auctions off its debt, it takes orders from a wide range of buyers who put in for the amounts they want at a range of yields, from low to high. The Treasury Department starts filling the orders at the lowest yield, followed by the next lowest. It goes up the range of yields until it runs out of Treasury’s to sell, that final sale yield is known as a “high yield” or “stop”.

When market participants are putting in their requests, they usually base the bids on where the securities are trading in the when-issued market. he sales are provisional because there’s always a chance the sale won’t be completed.

Thus, while the Bid-to-Cover may send a certain signal about the amount of demand for the sale, it doesn’t account for the fact that there could have been many wild bidders out there putting in orders that would never get filled.

Recently, there have been a series of kind of soft auctions as potential investors have anticipated rising yields as the Fed moves on rates during the year ahead. With Trumps tax and infrastructure plan the new issuance and the budget deal is helping to push yields higher in general.

In January it was reported by Bloomberg that China was looking to scale back its purchases of US Treasury debt. As has been mapped out in this paper there are some good reasons why Chinese officials might want to trim their purchases of US government debt.

  1. Federal Reserve is reducing its own holdings of Treasury debt
  2. Inflationary forces are emerging in the US economy
  3. The Fed will raise rates
  4. US Treasury yields will rise i.e. prices will fall

What Trump and the GOP are counting is that even if Beijing might like to stop buying US Treasuries, it will find it hard to so.  Why so? China buys US Treasury debt because its export industries earn enormous sums of foreign currency. Over the 12 months to November 2017, China ran a trade surplus of US$416 Billion.

These enormous trade surpluses have driven Beijing’s accumulation of US$3.14 Trillion in foreign currency reserves. Most of those reserves – probably US$2 Trillion are held in US Dollars and of that most is invested in US Treasury debt.

Trumps feels he can exploit the lopsided trade balance the U.S. has with China because China’s reserve managers don’t have much choice in the matter. The $14.7 Billion US Treasury market is about the only relatively low risk market out there large and liquid enough to provide China with investible assets for its foreign reserve stockpile.

However, the four points listed above mean that the Chinese may well be less than active bidders at upcoming auctions so driving to Bid-to Cover ration close to  two times. They will be happy to see soft auctions if it allows them to soak up cheaper Treasuries at say 3.0% on the T10 in the secondary as against when issued market.

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