Palisade Research - Wed, Nov 28, 2018

Foreign Buyers of Debt Vanish Just as the U.S. Needs Them Most

image of a businessman pondering beside a large question mark

Back at the beginning of Summer - I wrote an article (read here) highlighting the drastic disappearance of foreign buyers at U.S. bond auctions. Especially during a time when the U.S. Treasury needs more money than ever as they run huge deficits while collecting less in taxes.

I called this 'The Silent Problem'. . .

And it got its name because no one in the financial media was talking about this serious issue.

But now - seven months later - the problem's finally being noticed.

A recent article from Reuters wrote that, "overseas investors appear to be taking a pass on U.S. debt securities just as the Administration of President Donald Trump embanks on record sale of treasury bills, notes, and bonds to pay for its big tax cuts and spending increases."

Making matters worse - not only are foreigners not buying as much U.S. debt. But the current top overseas holders - China and Japan - are actually selling their U.S. government bonds.

China's selling because of the ongoing Trade/Currency war with the U.S. - as well as their own domestic need for liquidity.

And Japan's selling because of the strong U.S. dollar - which has crippled Emerging Markets and global asset prices throughout 2018.

line chart of China and Japan holdings of U.S. Treasuries since 2008

Yes - foreign countries do fluctuate with their buying of U.S. debt. Sometimes more so than others.

But this trend downwards has continued for years. And the real problem now is the collapse in 'direct-bidder' participation at U.S. Treasury auctions. . .

John Canavan - the market strategist at Stone & McCarthy Research Associates - said that, "direct bids have been exceptionally low. . . There's been a collapse, absolutely."

What are 'direct-bidders'?

These are a select group of buyers that are allowed to place direct orders with the U.S. government (instead of going through Wall Street).

Let me give you some context on how bad the "collapse" in demand really is. . .

Earlier in November - the Treasury sold 'direct-bidders' just 3% of the roughly $40 billion in three-year notes sold. This is the group's lowest amount bought in the last nine years.

But it's not just the short-term bonds seeing much lower demand. . .

It's all across the yield curve.

bar chart shows dropping direct bidding levels at last two U.S. Treasury auctions

Now - here's why the 'silent problem' really matters.

The U.S. Treasury needs a ton of money to meet their obligations. Especially since the Trump Tax Cuts are killing government revenue.

I've written before about the soaring U.S. deficit and the skyrocketing National Debt interest problem - you can read here.

Without foreigners sending their dollars back to the U.S. to buy government debt - the Treasury won't be able to pay for their spending. Or worse - the interest on the debt.

Foreigners are busy struggling against a strong dollar that's crippled their currencies and economies. Places like Turkey and China and Argentina need all the dollar-reserves they can find just to keep their currencies from collapsing and make good on their U.S. debts via the interest-payments due (more on that here).

Remember - all these countries binged on cheap U.S. debt during the Federal Reserve's easing years (post-2008 through 2015).

Thus they need huge amounts of U.S. dollars to pay back these bonds once they mature - or try and roll it over (aka refinance).

But with dollar-denominated funding getting more expensive - this will be costly and difficult for these countries and corporations to do.

Even more troubling is that there's nearly $3.25 trillion of Emerging Market debt coming due in the next two-years. This is another ticking time-bomb.

But - what's the main culprit here?

The deficient U.S. Treasury? The over-leveraged foreign countries? No - the main culprit behind these problems lay deeper.

It's the global dollar shortage being spurred on by the Federal Reserve's tightening. . .

Just think about it.

The Fed's rate hikes and Quantitative Tightening (aka QT - selling back all the bonds bought during QE) has sucked money out of the global economy.

And like we learned from Econ 101 - diminishing supplies with constant demand causes prices to rise. Therefore the U.S. dollar has strengthened significantly since 2014 (up over 22%) as the Fed began their tightening cycle.

The stronger dollar has made it much harder for foreigners to pay back U.S. debt because their currencies have sunk in value compared to the dollar (remember floating exchange rates - if the dollar strengthened - that means other currencies weakened).

Now I've written extensively about the global dollar shortage before many times. You can read my latest write-up here and get all caught up.

But the gist here is - these foreign countries can't buy U.S. debt when they need every dollar they can get to sustain their own economies and currencies (especially China).

The massive deficits by the U.S. Treasury have acted like a sponge. Sucking up all the extra available dollars abroad and domestic. But as we've seen from falling Treasury auction demand - the world's running out of spare dollars to give.

So - how will the Treasury get all its funding then?

Time will tell - but my long-held guess for 2019 is that the U.S. will slide into a recession because of the higher-rates and the Fed will have to quit their tightening and start easing (as well as monetizing the U.S. Treasury - aka buying bonds directly with printed dollars).

For now, it's clear that the collapsing demand for U.S. debt's becoming noticed by the mainstream financial media.

And the 'silent problem' is about to get very loud. . . publishes interesting contributor articles in addition to its own content. We have not verified any of the above details.

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