T-Bill Shower-Thoughts

After the tax cut passed in 2017 and the increase in spending passed in 2018, there’s one thing we know for certain about 2018: the quantity of US debt is certain to increase. From the tax bill alone, the Joint Committee on Taxation—a nonpartisan entity—estimated that the federal deficit will increase by $1 trillion even after the inclusion of economic growth. This, paired with the increase in spending under the new spending bill should increase the national deficit and thereby increase the federal debt. In addition to the two pieces of legislation, this past January China slowed down its purchasing of US Treasuries. Without getting too much into exchange rates and trade, China has kept the value of its currency, the yuan, cheap compared to that of the US dollar. It does this by taking  the dollars it receives from exporting its goods to America and purchasing US debt, or US Treasuries. This is done in lieu of purchasing yuan with US dollars, which would increase the value of the yuan relative to the dollar. This makes Chinese imports for Americans inexpensive. If China slows down its purchases of dollars, the yuan will appreciate relative to the dollar. This would be a change from the status quo. In a perfect world, over time the yuan and dollar should equal each other, and the trade deficit would narrow.

These two segments of news have led me to two questions. First, we know that the US Treasury issues debt instruments—T-bills, notes, bonds, treasury inflation protected securities (TIPS), and floating-rate notes—in order to finance the government. The proceeds from the sale of these securities is used to pay for the Federal government’s spending. We’re used to this—since 1970 the US government has run a deficit all but four years, 1998 to 2001. So does the treasury still issue debt during a surplus? And our second question, what would happen if China not only stopped purchasing US debt, but also sold off its positions in the secondary markets?

At first, the answer seems simple. The Treasury probably doesn’t issue debt during a surplus, as it has enough tax revenue to pay for the spending, right? Logically, this makes sense during the short-run, however, this isn’t the case in real life. During the 1990s budget surplus, the Treasury slowed down on issuing debt instruments, but didn’t stop all together. While there wasn’t an immediate need to finance the government, the Treasury “rolled over” the debt and actually issues more debt. In addition, it may choose to change the maturities of new issued bonds. Today, there are about 270 auctions for US debt instruments per year. If either the US Treasury held less auctions or changed the maturities this would no doubt affect the global financial markets.

It’s important to remember that while most debt is held by the public or foreign governments, a sizeable portion of the debt—about $5.3 trillion—is held by the government in trust funds like Social Security. Government trust funds like Social Security are only allowed to invest in government securities, and unlike other investors, they cannot sell the securities before maturity.  While the US Government has only run a surplus for four years, what would happen if it ran it for an extended period of time, and therefore the Treasury issued new debt with either shorter or longer maturities, and therefore lower or higher interest rates--or just stopped issuing debt all together (a fun, but impossible scenario)?

Considering that US Treasuries are the basis of our global financial system as the symbol of the risk-free rate of return, it would undoubtedly complicate pricing and yields. In addition, the  lack of debt would make monetary policy tough for the Fed to execute. However, if there were no securities issued, government trust funds would also have no place to invest their money. While this is a highly (if not impossible scenario) it’s interesting to think about.

If the US government stopped issuing debt it would have drastic effects on financial markets. But what if demand for US dried up, specifically, if foreign countries like China stopped purchasing out debt? Again, this is another highly unlikely hypothetical scenario. Export-intensive countries like China benefit heavily from devaluing their currency relative to the USD. Let’s say China stops buying US debt, and also liquidates its current holdings in the secondary markets, what happens?

Well , from the liquidation for about $1.2 trillion in assets, the price of the treasuries would drop and yields would increase. It’s important to remember that a factor of US treasury yields being so low—in addition to being a safe asset—is the fact that they’re in high demand. The US does not have to offer a higher yield to encourage investors to purchase them. So, yields across maturities would most likely increase. In addition, the value of the yuan would increase relative to the dollar, making Chinese imports more expensive. The USD would also depreciate, most likely boosting US exports. It also means that US savings would have to increase to offset the increase in net exports.

However, if $1.2 trillion in securities we’re liquidated, it might cause a panic sell-off in fixed-income markets as investors saw the value of bonds in their portfolio drop precipitously. It would not be a good day in the financial or goods markets—but again, this is a highly unlikely situation.

While improbable hypothetical scenarios are fun to toy around with, it’s probably best that they remain improbable. What we can (most likely) expect is a continuation of the status quo. The deficit and national debt is likely to increase, and unless US-Chinese relations completely implode, China probably won’t liquidate its holdings of US debt.

 

 

 

Sources:

Burtless, Gary. “If China Stops Buying Our Debt, Will Calamity Follow?” Brookings (blog), November 30, 2001. https://www.brookings.edu/opinions/if-china-stops-buying-our-debt-will-calamity-follow/.

Carney, Jordain. “CBO: Senate Tax Bill Increases Deficit by $1.4 Trillion.” Text. TheHill, December 2, 2017. http://thehill.com/blogs/floor-action/senate/362905-cbo-senate-tax-bill-increases-deficit-by-14-trillion.

Driessen, Grant. “How Treasury Issues Debt.” Congressional Research Service, August 16, 2016. https://fas.org/sgp/crs/misc/R40767.pdf.

“How Long Has the U.S. Run Fiscal Deficits? | Investopedia.” Accessed February 24, 2018. https://www.investopedia.com/ask/answers/021115/how-long-has-us-run-fiscal-deficits.asp.

Kaplan, Thomas. “Trump Signs Budget Deal to Raise Spending and Reopen Government.” The New York Times, February 8, 2018, sec. Politics. https://www.nytimes.com/2018/02/08/us/politics/congress-budget-deal-vote.html.

Patel, Jugal K. “The Senate’s Official Scorekeeper Says the Republican Tax Plan Would Add $1 Trillion to the Deficit.” The New York Times, November 28, 2017, sec. U.S. https://www.nytimes.com/interactive/2017/11/28/us/politics/tax-bill-deficits.html, https://www.nytimes.com/interactive/2017/11/28/us/politics/tax-bill-deficits.html.

“The Worry About Giant Foreign Buyers of U.S. Debt.” Bloomberg.com, January 11, 2018. https://www.bloomberg.com/politics/articles/2018-01-11/the-worry-about-giant-foreign-buyers-of-u-s-debt-quicktake-q-a.

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