[Financial Planning for the 100-Year Life] U.S. Treasury-Induced Financial Instability May Lead to Contraction in Consumption and Investment

Concerns Over Plummeting Treasury Prices Amid Weak Demand
Potential Hard Landing for the Consumption-Driven U.S. Economy

With the debt ceiling negotiations concluded last June, the U.S. federal government is now able to issue more Treasury bonds. However, if there is insufficient demand for these bonds, their prices could plummet, potentially destabilizing financial markets. At the end of March, the U.S. federal government had issued Treasury bonds totaling $31.4584 trillion. Foreign investors hold 23.9% of these bonds, while the Federal Reserve (Fed) holds 18.2% (the remainder is held by private investors).

The proportion held by foreign investors has been steadily declining since March 2015, when it was 34.0%, and it is expected to decrease further as some countries, including China, continue to sell U.S. Treasuries. Since joining the World Trade Organization (WTO) in 2001, China has exported goods worldwide by producing them cheaply based on low labor costs.

In particular, from 2001 to 2022, the U.S. trade deficit with China reached $6.2 trillion, reflecting the large volume of goods supplied to the U.S. China used some of the earnings from the U.S. to purchase U.S. Treasuries. China's holdings of U.S. Treasuries surged from $477.6 billion in 2007 to $1.27 trillion in 2013. However, China has been selling U.S. Treasuries since 2014. By May of this year, its holdings had decreased to $846.7 billion.

Japan, which holds the largest amount of U.S. Treasuries, has also been selling recently. Japan’s holdings dropped from $1.3008 trillion at the end of 2021 to $1.0968 trillion in May this year. It is reported that Japanese insurance companies, among the major players in global finance, are selling U.S. Treasuries. Although U.S. interest rates are much higher than Japan’s, when factoring in currency hedging costs, the returns are not higher than those from Japanese government bonds.

While foreign investors are reducing their U.S. Treasury holdings, the Fed is also in a position where it must sell U.S. Treasuries due to quantitative tightening aimed at stabilizing inflation. The Fed’s holdings decreased by $541.8 billion from $6.255 trillion in March 2022 to $5.7132 trillion in March this year. Quantitative tightening is expected to continue for the time being.

U.S. financial institutions are supposed to buy these Treasuries, but this is challenging. One of the main reasons behind the collapse of Silicon Valley Bank in March was excessive Treasury purchases and the subsequent price decline.

Considering this supply and demand situation, U.S. Treasury prices could fall significantly (which means Treasury yields would rise). Of course, economic growth rates and inflation rates, which determine interest rates, are expected to moderate the rise in rates to some extent.

Rising interest rates are increasing household interest burdens. The ratio of interest payments to disposable income, which was 1.2% in March 2021, rose to 2.4% in June this year. This is higher than the long-term average of 1.9% since 2010. If interest rates rise further, consumer spending will decrease, and bankruptcies among financially weak companies will increase. At the end of March this year, U.S. corporate debt (bonds issued plus loans) was 48% of GDP, significantly higher than the long-term average of 39% since 1966.

If consumption and investment contract, corporate profits will decline, potentially causing stock prices to plunge. Falling stock prices would further suppress consumption. This suggests the possibility of a hard landing for the U.S. economy, which is consumption-driven.

In August 2011, S&P, one of the world’s major credit rating agencies, downgraded the U.S. sovereign credit rating by one notch, citing the high national debt among other reasons. Since then, the U.S. domestic and external imbalances have worsened. Government debt as a percentage of GDP increased from 94.6% in 2011 to 118.6% in the first quarter of this year. Over the same period, net external debt surged from 28.6% to 63.1% of GDP.

On the 1st (local time), Fitch Ratings abruptly downgraded the U.S. sovereign credit rating from 'AAA' to 'AA+'. This is the first time in 12 years since 2011 that the three major international credit rating agencies have downgraded the U.S. sovereign credit rating. Moody’s also holds a negative outlook. If the issuance and absorption of Treasury bonds do not proceed smoothly, these issues could materialize simultaneously.

Kim Young-ik, Adjunct Professor, Graduate School of Economics, Sogang University