It is the crux of our economy. It is the all-important foundation upon which economics is built. It is supply and demand and the constant attempt to reach an equilibrium that our policymakers are now dealing with in their attempt to revive our economy. To fund the astronomical size of the stimulus packages the White House has authorized, as well as to finance the budget deficit, the government has had to issue record amounts of debt.
As the government sells its debt and increases the supply of bonds in the marketplace, it must lower the price to find sufficient buyers, driving interest rates on the debt up. On Friday, the yield on 10-year Treasury notes rose 13 basis points to 2.89%, as the price dropped $11.25 per $1000 face amount to 98¾.
The fear that the Federal Reserve has flooded the market with debt and thrown the supply-demand relationship out of balance caused the Fed to announce that they will buy back up to $300 billion in Treasuries, the first time they have done so since the 1960s. They have already begun the buy back process, purchasing $31 billion so far. On the other hand, the government plans to sell $59 billion of debt split among Treasury Inflation Protected Securities (TIPS), 3-year notes, and 10-year notes in the upcoming week.
Concurrently issuing and buying debt has policymakers working at cross purposes. The Treasury must continue to issue debt to stimulate the economy, but the Federal Reserve wants to monitor the supply of debt so that interest rates don’t rise too high. The problem that arises when the government must issue so much debt and increase the supply in the market is that they must lower the price and increase the yield to entice buyers. When the yield goes up, this increases the cost of debt for corporations who want to finance new projects, which in turn lowers the Net Present Value of those projects, making them less likely to accept the projects. When the government raises interest rates through its use of fiscal policy, it crowds out others looking to invest.
With the credit markets as tight as they are, corporations are already having difficulty raising funds and rising interest rates on top of that will only hinder corporations’ willingness to invest, which is the real source of economic growth; the government cannot spend trillions of dollars in perpetuity to keep our economy afloat. If the government continues to issue debt and crowd corporations out of the debt market, it will increase our reliance on the government, simultaneously prolonging our recession.
This “crowding out” is the reason that the Federal Reserve is now getting involved in buying the Treasury’s debt. By announcing that they would buy up to $300 billion in debt, the Fed was hoping to increase the demand for debt in the market, lowering the yield on debt.
There are three reasons that the announcement of buybacks failed to accomplish its goal of lowering yields:
- $300 billion of government debt is just a small drop in the pond. Goldman Sachs (GS) estimates that the government needs to issue $3.25 trillion of debt this year, and in all reality the government can just continue to issue as much debt as it needs regardless of how much of its debt the Federal Reserve buys. What we have here is another AIG-like situation where the government gave them $180 billion and the $170 million that was doled out in bonuses was an insignificant proportion. $300 billion compared to $3.25 trillion is an insignificant amount and might not even make a difference.
- Even though the Federal Reserve has already bought back $31 billion of Treasuries through five buyback operations and has five more planned over the next two weeks, the government is working against them because it will be issuing approximately the same amount in new debt over the same time period.
- Eventually, the Federal Reserve will have to sell these Treasuries back into the market. They cannot hold onto the debt forever. So, when they sell the debt back, the same supply issues will occur, prices will go down, and the crowding out will occur all over again.
These last two reasons, coupled with the market’s reaction in that yields did not go down, lend credence to the Rational Expectations hypothesis, because potential investors realize that even if yields go down now, they will eventually have to go back up in the future. It is my estimation, however, that the more likely reason that yields failed to drop was that the $300 billion was just too small an amount to make a difference, especially if the government can just continue to issue more debt.
On an international level, the Chinese government has expressed resentment at the Fed’s actions. As one of the largest holders of the United States’ debt, China is upset that the Federal Reserve is attempting to increase demand, driving prices higher, only to deflate prices later as the Fed eventually sells the debt back. China’s concern stems from price fluctuations on the debt that they hold as well as the value of that holding in the face of a dollar with diminishing value; as the United States issues more debt, inflation becomes a growing concern which would decrease the value of the dollar and subsequently the value of their investment.
It will be interesting to see if the Federal Reserve can keep interest rates low enough to entice corporations to invest as the government continues issuing debt in its attempt to stimulate the economy, especially with the need to steady foreign relationships in the mix as well.
- Christopher Holden
Disclosure: None.
