There’s hardly a week that goes by where a news outlet or pundit isn’t calling for interest rates to go significantly higher. As the Federal Reserve further cuts its monthly bond purchases from its quantitative easing program and is expected to end its purchases in March, many still believe there’s little demand for U.S. government debt. Confounding these so-called experts are the monthly Treasury debt auctions, where foreigners continue to purchase large amounts of U.S. government debt.
The behavior of foreign investors and central banks baffles most investors and professional money managers. Many look back to the 1970s when inflation seemingly led interest rates higher, so it only seems logical with the year-over-year rate of change in the consumer price index at the highest level since early 1982 that yields must rise significantly.
For seemingly unknown reasons, foreign investors and central banks seem overly eager to buy large percentages of U.S. Treasury bills, notes, and bonds at the regular monthly auctions. Should interest rates rise, as Wall Street predicts, those foreign investors and central banks are almost assured of losing money.
With eager anticipation, investors hope the next Treasury auction will see weak demand to validate their view that yields must rise, yet it never happens. Despite the continued strong demand from foreign investors and central banks, speculators continue to press their short bets on U.S. Treasuries as they hope to cash in big on rising rates.
The recent earnings reports by the major banks gave further fuel to the view that interest rates must rise. Many of the large commercial banks indicated in their quarterly reports that they were now interested in originating more loans rather than purchasing reserves. Since bank reserves are created when the commercial banks buy U.S. Treasury securities and mortgage-backed securities, it suggests that without the commercial banks buying as many bonds that interest rates will assuredly rise.
The comments by many of these banking experts are that those who are bond bullish better hope foreign demand for U.S. government debt remains strong. While there’s little evidence to support this view, it does make sense at face value. Should the commercial banks scale back their purchases, the burden of absorbing the U.S. government’s deficit spending falls on the backs of foreign investors and central banks.
In the face of rising inflation and assumedly higher interest rates, it’s only a matter of time before foreign demand disappears. Without a healthy appetite for U.S. government debt by two of the largest purchasers of U.S. government debt outside the Federal Reserve, rates must rise. Yet foreign demand remains strong and is most likely to continue to be strong regardless of how high consumer prices rise.
Foreign demand for U.S. government debt is a byproduct of our global monetary system and the U.S. dollar being the global reserve currency. When the global monetary system is functioning properly, foreign investors and central banks should have a strong demand for U.S. government debt. While demand declined during the pandemic, foreign demand for U.S. government debt is likely to remain strong as the global economy reopens and supply chain backlogs normalize.
When dollars are transferred overseas through trade with the United States, foreign investors and central banks choose to hold some of those dollars in reserve. Rather than sit on cash that doesn’t pay a yield, they choose to buy U.S. government securities to hold them to maturity. The more goods and services foreign countries export to the United States, the more dollars they accumulate and the more reserves they need to purchase.
When gold was the global reserve currency, a large stockpile of yellow metal was considered a sign of prosperity from an exporting nation. As gold bars piled up in vaults, those net-exporting countries were building up a safety net. Today, U.S. Treasury securities function as gold did when gold was the reserve currency.
The accumulation of U.S. Treasury securities by a foreign country is a sign of prosperity and wealth in a dollar-based global reserve system. To accumulate more U.S. government debt, a country simply needs to be a net exporter with the United States. When supply chains were shut down during the pandemic, exports to the United States also ground to a halt.
Based on the most recent data, more than 100 ships are sitting somewhere off the ports of Long Beach and Los Angeles waiting to berth. When cargo is unloaded, it’s paid for in dollars, and those dollars are transferred back to the foreign countries where the cargo originated. The excess dollars that get transferred back will get converted to reserves by their foreign owner, who would rather hold interest-bearing Treasury securities than cash.
As foreign producers race to export as many low-cost goods and services while the United States is mired in high inflation, the United States will export large amounts of dollars overseas in exchange. Some of those dollars will be used in commerce and the rest will be converted into reserves.
The reason foreigners are buying U.S. Treasury securities in mass and will continue to do so is simply explained as foreign producers exporting large amounts of goods and services to the United States that will be paid for in dollars. As long as they continue to export, foreign demand for Treasury securities will remain high and Treasury yields will remain low.
