Foreign Purchases of US Treasuries and Agencies are decreasing
Copyright Bud Conrad September 16, 2005
As discussed in previous columns for this site, the U.S. economy relies heavily on foreigners purchasing U.S. debt to keep the economy running smoothly. Foreign central banks have been keeping dollar values high and interest rates low by buying U.S. Treasuries in huge quantities. In fact, between 70% and 90% of U.S. government Treasuries issued in recent years were purchased by foreigners.
In case you are new to this story, for several years now I have been following a weekly indicator produced by the Federal Reserve that gives a close indication of foreign purchases of Treasury and Agency debt. It is now showing that foreign central banks are dramatically slowing their purchases through the Fed. Those purchases have fallen from a peak annual rate of $400B in early 2004 to about $200B in 2005 and now to an annualized $100B over the last quarter.
It has been my contention that if foreigners slow their purchases, the decrease in demand would drive rates up. This chart shows that calculation overlaid with the 10 year rate inverted. The blue line is the amount of custody purchases and the magenta line is the interest rate with the scale inverted. See my article of 02/14/05 posted in the KitcoCasey archives for a more detailed description of how this indicator was developed.
Bush’s speech last night confirmed that he plans to spend whatever it takes to rebuild New Orleans. We are at $61 billion already. Washington types throw around numbers as high as $200 billion without the slightest indication that they understand the true meaning of a billion. There was no “Hard Choice” of tax increases, or cutting other programs mentioned. To put that in perspective, $200 billion is about the annual Iraq war cost.
Speaking of which, while the Katrina catastrophe has pushed Iraq off the front page of the news, Iraq remains an open wound: Two days ago we saw 152 deaths, the worst casualty toll since the US invasion. Despite differing political opinions about the Middle East, its costs will continue to drain the Treasury, meaning the government will be forced to keep borrowing, bidding up interest rates in order to keep foreigners buying.
Meanwhile, the $60 + price of oil is already stressing the economy and will inevitably be inflationary for such economic building blocks as chemicals, transportation, fertilizer, gasoline and all oil based products.
With the PPI running at 7% and CPI at 5% for August, 10 year Treasuries at 4.25% are below inflation, meaning they are now providing buyers a negative yield. September inflation is expected to be even higher as Katrina’s affect on gasoline price moves through the system. If inflation remains as persistent as oil prices have been of late, the market will require increased interest rates to keep foreigners in the buying mood.
It is hard to overestimate the importance of foreign buying: it was that buying of U.S. Treasuries that served as the driving force that has kept U.S. long-term interest rates low. Foreign buying takes pressure off long-term rates, supporting continued borrowing for real estate, durables and business expansion. Should this drop in the level of Treasuries purchases by foreigners shown on the accompanying chart continue, it is likely to force rates higher, putting pressure on already debt-laden consumers… and even prove to be the pin that pops the housing bubble.
The last time the drop in foreign buying was this large was in February 2005, which was followed by a rise in interest rates in April from 4% to 4.5%. My arrows emphasize that the general trend of these purchases is now down, a change from what we’ve previously seen.
Economists have been calling our trade deficit and budget deficit “unsustainable” for years and the markets have ignored them. More recently, the importance of the foreign re-investment of the trade deficit as a source of capital has become recognized. It is counter intuitive that the trade deficit, which is the source of these foreign investments, actually helps our short term interest rate and inflation. The assumption is that foreigners will automatically reinvest whatever trade deficit we have with them. But that now looks to be changing, and with it there could be a big shift for the stability of the US dollar, inflation, and interest rates.
As a present discounted value of potential catastrophe, I am amazed at the conundrum of how low long term rates have stayed. That maybe about to change.