The U.S. Treasury next month will go back to relying on the kindness of strangers like never before to purchase the nation’s burgeoning debts — and taxpayers may have to pay higher interest rates to attract enough foreign investors, analysts say.
Though a significant rise in interest rates could be toxic for a softening U.S. economy, the Federal Reserve has said it will end its program of purchasing $600 billion in U.S. Treasury bonds as planned on June 30. The Fed is estimated to have bought about 85 percent of Treasury’s securities offerings in the past eight months.
That leaves the Treasury, which is slated to sell near-record amounts of new debt of about $1.4 trillion this year, without its main suitor and recent source of support, and forces it back into the vagaries of global markets. Among the countries that will have to step forward to prevent a debilitating rise in interest rates are China, Japan and Saudi Arabia — and even hostile nations such as Iran and Venezuela with petrodollars to invest, according to one analysis.
The central bank launched the unusual bond-buying campaign last fall in an effort to lower interest rates and boost the sagging economy — and it was successful at drawing down long-term interest rates to record lows last winter. In particular, 30-year fixed mortgage rates fell to unprecedented lows near 4 percent and spawned a refinancing wave that helped consumers to discharge debts, purchase homes and increase spending.
But by the start of the year, a pickup in inflation — led by a surge in oil and other commodity prices that some economists blamed on the Fed’s easy money policies — wiped out the boon for consumers and home buyers and started to weigh on the economy. With the economy relapsing back to tepid rates of growth around 2 percent, some Fed officials argue that it should continue the easing program, but fear that the commodity boom could turn into a serious inflation threat makes it difficult for the Fed to do so.
Federal Reserve Chairman Ben S. Bernanke said in a speech Tuesday that the Fed remains on track to withdraw from the Treasury market, stressing that the central bank must remain vigilant against inflation at the same time it tries to nurture the economy back to healthy growth.
Not an easy task
The end of the Fed’s program would never be easy given the huge onslaught of scheduled Treasury borrowing, but the task will be more difficult because foreign investors in the past six months have been reducing their sizable holdings of U.S. debt, not increasing them.
That means to get those buyers back, the Treasury may have to raise the rates it pays on the debt.
“With the Fed pretty much out of the picture after June, it seems clear that foreign demand for Treasuries holds the key going forward,” said David Greenlaw, an analyst at Morgan Stanley. “Continued heavy buying by the largest foreign holders of Treasuries will probably be necessary” to prevent interest rates from rising, he said.
China and Japan remain the largest foreign buyers of Treasury debt, followed by oil exporters such as Saudi Arabia and Qatar. Even oil exporters that are hostile to the U.S. such as Iran and Venezuela have been among the buyers supporting the Treasury in the past, according to Morgan Stanley estimates.
China and many of the oil exporters often channel their investments through London and such offshore investment havens as the Channel Islands, so the origin of the funding is sometimes difficult to track. The uncertainty of where the money is coming from in itself will cause rates to rise and increase volatility in the Treasury market after the Fed exits, Mr. Greenlaw said.
Brazil, Taiwan and Russia also are among the Treasury’s major creditors. But many countries have been cutting back on their purchases of U.S. securities in the past six months out of concern about the rapid decline of the U.S. dollar and rising inflation, which hurts their investment values.
Vassillli Serebriakov, an analyst at Wells Fargo, said many foreigners were put off by the Fed’s bond-purchase program, which appeared to trigger a foreign sell-off of about $100 billion in Treasury holdings since last fall.
In some countries, the program was portrayed as the Fed “printing money” to finance profligate congressional spending and tax cuts — a charge the Fed vehemently denies.
Still, given the wariness overseas about the Fed’s policies and untamed federal deficits, going back to relying on foreign buyers to finance the lion’s share of the debt could be tricky, he said.
“The key question is to what extent one can expect the recent deterioration in the long-term capital flows to be reversed,” he said.
An undetermined future
Foreign investors have applauded the Fed’s decision to end the program as it improves the prospects for keeping a lid on inflation. But they will continue to be concerned about uncontrolled deficits and declines in the dollar that diminish the value of their investments, he said.
“Some of the reduction in Fed Treasury purchases could be replaced by increased demand from foreign investors, but this channel is less certain,” he said.
Peter Schiff, president of Euro Pacific Capital, said he does not expect enough foreign or private buyers to step forward and purchase Treasury’s huge slate of debt offerings — a potentially catastrophic development that he thinks will force the Fed to backpedal and renew its bond-buying program.
“Do they expect the Chinese to reverse course on their current policy and start heavily buying U.S. debt once again?” he asked.
“That seems extremely unlikely given” that China has been investing less in Treasury bonds partly in response to demands from the United States that it stop skewing trade relations between the countries by hoarding huge surpluses of dollars it earned through trade and reinvesting them in Treasuries.
Mr. Schiff noted that Bill Gross, the head of America’s own Pimco bond fund, the largest buyer of bonds worldwide, recently reduced Pimco’s holdings of Treasuries to zero out of concern that they weren’t yielding enough given the risks of inflation and deficit spending.
“It is not clear what would convince Gross to get back into the market with both feet, but one might expect at minimum it would take much higher interest rates,” Mr. Schiff said.
Jeffrey Kleintop, chief market strategist at LPL Financial, said he is not worried about the Treasury finding buyers or about other market disruptions as the Fed pulls back.
“While interest rates are likely to rise modestly, we do not anticipate a spike resulting from the lack of Fed buying that would put the economy at risk,” he said.
A failure by Congress and the White House in coming weeks to agree on a plan to curb deficits would be a much bigger problem for the markets, Mr. Kleintop said.
“The budget and debt-ceiling debate may be of more importance since fiscal policy could tighten sharply or a failure to control the deficit could spike interest rates, in either case putting the economy at risk,” he said.