Wednesday, August 15, 2018

No Seller, Let Alone China, Can Disrupt US via Selling US Treasury's...But the "Why" Ain't Good

I often read that China may retaliate against US trade sanctions by further decreasing their US Treasury holdings, sending Treasury yields significantly higher, thus blowing out US deficit spending on interest payments.  Trouble is, Chinese Treasury holdings peaked in 2014 (on an annualized basis) and have been declining since.  The Chinese have not only ceased accumulating US Treasury debt, despite continued record trade surplus' with the US resulting in significant dollar surplus', but have been decreasing their holdings.  All this, according to the Treasury International Capital (TIC) system.

But this postulation that the Chinese could wound the US via selling a portion (or all) of its Treasury holdings (as Russia recently did) is submarined by the recent actions of the Federal Reserve.  I say this based on the magnitudes greater accumulation and subsequent dumping of specific maturities of US Treasury debt done by the Federal Reserve.

The Federal Reserve accumulated almost $800 billion in 7 to 10 year US Treasury debt (red line, chart below) from 2009 to 2013, and then subsequently dumped $600 billion from early 2014 through the most present August 2018 data.  And the impact on the 10 year yield (blue shaded area, chart below)...essentially zero.  Yes, while the Fed rolled off and/or sold off 7 to 10 year holdings, they were busy buying short term debt.  But this still meant someone had to step up in duration and buy all that longer duration debt the Fed no longer wanted.
To put the relative size of China's 7 to 10 year holdings in perspective to the Fed's like holdings, the chart above estimates that a third of Chinese Treasury holdings (likely an overestimation) were of the 7 to 10 year variety (gold line).  The Fed has already rolled off / sold off 1.5x's more 7 to 10 year debt than the Chinese even have.  The impact on the 10 year Treasury yield while the Fed plus China sold off / rolled off a combined $650 billion of 7 to 10 year debt...essentially zero!!!

But to explain why the yields did not react (and likely never will), I have to take a step back and highlight the changing underlying population and demographics that are driving this.

Population / Demographics
The 25 to 54 year old US population and employment among them (and subsequent capability to consume) consistently grew in the post WWII period until 2000.  But in 2000, the population growth decelerated (brown line, chart below) and employment among them significantly fell (blue line).  The 25 to 54 year old population has only minimally grown since 2000 and not grown at all since 2007...but employment among the core (that makes up 70% of the US workforce and pays the vast majority of the Social Security taxes) is essentially right where it was in 2000.

To broaden the view, check the 15 to 64 year old US total population (red line, chart below) versus year over year changes in that population (blue columns).  Obviously, the peak year over year population growth took place in 1998 (adding 2.7 million persons in that year alone) but growth has decelerated over 80% since that peak growth.  The heyday of fast growing populations (at least, those under 65) and increasing quantities of employees, tax payers, and/or consumers has run its course...yet politicians and the Fed still target and tout economic growth, as if nothing had changed.  However, the continued growth in US employment (and consumption) is simply mathematically running out of able bodies (Detailed HERE).  Plus, the population growth estimates through 2030 shown below are premised on continuing significant rates of immigration.  Absent a significant net inflow of immigrants, the under 65 year old population will be in outright decline.  Of course, the changing population growth and demographics (particularly among the populations that do the vast majority of consuming) is a global issue (Detailed HERE).

Conversely, the 65+ year old population really began rocketing upward about 2008 and will hit its year over year peak growth in 2024.  The population of 65+ year olds will increase by 20+ million from '18 through '30 versus an increase of less than 4 million among the 15 to 64 year olds.  But worse still, over half that growth will be among the 75+ year olds.  This will be the death knell of many poorly thought out programs premised on perpetual growth.
This has resulted in a debt fueled "extend and pretend" frenzy.  The chart below shows annual 15 to 64 year old US population growth (yellow line) versus stacked columns showing annual consumer, federal, and corporate debt growth.  One has to be very highly compensated to miss the explosion in debt tied to the slowdown in core population growth.
Federal Debt and the Intra-governmental Trust Fund
First, a look at US federal debt, split between US Public debt (marketable) and US Intra-Governmental debt (Social Security and other trust fund surplus').  Up to 2007, the Social Security and other federal trust fund surplus' were mandated to purchase and hold US debt, to the tune of 44% of total US debt.  But since 2007, federal debt issuance has been skyrocketing while the pace of IG purchasing continues decelerating.  This means 85% of Treasury debt issued since '07 has been marketable (marketable debt has risen $10.6 trillion versus a $1.8 trillion increase among the IG trust funds).  This is a clean tripling of marketable debt and the IG trust funds will peak and begin declining likely prior to 2020, and 100%+ of all Treasury debt will be marketable from that point forward.

Which is to say, the remaining three sources of buying will have to really step up their appetite for US debt.  But foreigners and the Federal Reserve have already ceased buying (net), and the sole buyer remaining is the domestic public (domestic insurers, banks, mutual funds, pensions, etc.).

From 2000 to 2007, foreigners purchased $1.3 trillion in net Treasury debt but from 2008 through 2014, foreigners stepped up to the plate nearly tripling their holdings, buying $3.8 trillion in net debt.  However, since late 2014, foreigners have not only ceased buying US debt (net) but have followed the Fed's lead and are presently net sellers.
Focusing on the three largest foreign holders of US Treasury's; China, Japan, and the BLICS (Belgium, Luxembourg, Ireland, Cayman Islands, Switzerland).  China holdings peaked way back in 2011 while Japan and the BLICS peaked as QE ended and have been declining since.  Upon the termination of QE, foreigners simply lost their appetite for US debt.
Below, a close up on the BLICS.  What is noteworthy is the great scramble in these shadow banking capitals, particularly during each of the recent financial upheavals.  And judging by the sharp movements again taking place in these unregulated, off-shore shells for hot money...things are again (perhaps not surprisingly) in upheaval.
Federal Reserve
The chart below details the size and shifting maturities of the Treasury's held on the Federal Reserve balance sheet from 2003 to present.  The total holdings of Treasury's tripled and the Fed has now decreased total holdings from the peak by about $130 billion.  However, the maturities held on their balance sheet have radically changed.  The Fed has maintained nearly all their 20 to 30 year holdings. sold off two thirds their 7 to 10 year holdings, while initially buying in bulk 1 to 5 year but now piling into less than 1 year debt.
The Fed (and foreigners) ceased buying and turned to net sellers by 2015 as the IG trust fund buying continued decelerating against ramping Treasury issuance.  This meant there was only one buyer left, the domestic public.  But for domestic buyers, the spread or profit to be gleaned between borrowing short term to buy longer duration bonds was falling from nearly 300 basis points in early 2014 to the current 24 basis points (grey shaded area in the chart below versus Fed's shifting holdings).

Essentially, the utilization of leverage to enjoy the spread of borrowing short to buy long nearly evaporated while the relative benefit of buying short has outweighed the risk of going long.  But we are to believe that as the Fed went on a short duration buying spree since 2015 (purple line below) coupled with a 7 to 10 year dump (yellow line) domestic sources piled into 7 to 10 year US debt (unleveraged?) to soak up the flood of assets destined to underperform inflation?!?
Updated Treasury Holdings:
Late this week the Fed updated it's holdings (after publishing the above) and although the total Treasury holdings "only" declined by $13 was the maturities of the balance sheet which changed significantly.  The chart below, from 2015 to present, details it was another $39 billion reduction in 7 to 10 year debt and $12 billion reduction in 1 to 5 year holdings offset with additional holdings of $32 billion in under 1 year maturities and an additional $6 billion of long bonds (20 to 30 years)...and on the week in which the Federal debt crossed the $21.4 trillion mark, 10 year yields again fell despite the surge in primary and secondary supply.
Domestic Public
So who among the domestic public is buying all that 7 to 10 year unleveraged debt, destined to underperform inflation?  Not banks, or insurers, or state and local, according to the Treasury Bulletin its a group originally intended as a catch all for the rounding errors, "other".  So "other", with an assist from mutual funds, is saving America from having to face an interest rate Armageddon!?!  The Treasury Bulletin defines "other" as follows; "includes individuals, Government-sponsored enterprises, brokers and dealers, bank personal trusts and estates, corporate and non-corporate businesses, and other investors."  Make of that what you will, but I'm pretty confident buying 7 to 10 year debt, at this point, would be a quick means to significantly underperform and thus, real buyers wouldn't do so...which means it's a buyer(s) without profit motive that is "extending and pretending" our current economic and financial system for as long as possible.  How much further this can go is difficult to say...but the shrinking number of  winners and growing numbers of losers is more easily calculated.
In short, Bernie Madoff would blush at the farce that is now the US Treasury market (further manipulating all downstream interest rate sensitive markets).  A little lie or meddling led to more lying and more meddling...and suddenly the free market no longer exists.  It should be clear that a buyer without profit motive is intervening in the Treasury market to maintain a bid and sustain continued low rates on US debt...all this because America has matured but those in control still want to synthetically maintain growth rates (hello China) via unrestrained debt issuance.  Regardless how much debt the US issues and how few buyers remain, don't look for interest rates to rise in kind.