- An advisor to President Putin suggested that if the US dares to impose sanctions on Russia for invading Crimea, Russia and its allies should retaliate by dumping US Treasury bonds.
- Should US policy-makers take this threat seriously? Should investors factor this risk into their assessments of the US economy and US financial asset prices?
- The answers to these questions are clear, although they will surprise many people.
Last week it was widely reported in the press that Sergei Glazyev, a man described as an "advisor" to President Putin, issued the following "threat" in response to the possibility of US sanctions on Russia:
"We hold a decent amount of treasury bonds - more than $200 billion - and if the United States dares to freeze accounts of Russian businesses and citizens, we can no longer view America as a reliable partner," he said. "We will encourage everybody to dump US Treasury bonds, get rid of dollars as an unreliable currency and leave the US market."
I have decided to address Mr. Glazyev's threat because many people around the world fear (or hope) that large holders of US sovereign debt such as Russia and China could inflict major damage on the US economy if they decided to dump their Treasury bonds onto the market all at once. Indeed, many analysts believe that the mere threat of engaging in such "financial warfare" provides US rivals with significant leverage that can enable them to further certain geopolitical and strategic objectives.
Should investors worry about this sort of threat? What would happen to the US economy and financial system if Russia and/or other nations dumped their US Treasury bonds on the market? What would be the effect on US financial assets such as Treasury bonds (NYSEARCA:TLT), stocks (NYSEARCA:SPY), gold (NYSEARCA:GLD) and the US Dollar (NYSEARCA:UUP)?
Some Background On The Source Of The Threat
Later in this article, I will address what would happen if Russia were to actually dump its holdings of US Treasury bonds. However, before exploring such an eventuality, I think it may be worthwhile to situate Mr. Sergei Glazyev's comments within the context of Russian politics and policymaking, and in light of his particular background.
First, it is important to understand that Mr. Glazyev does not serve in any kind of policy-making role nor is he part of Putin's inner circle of advisors. Glazyev is a Ukrainian born Russian politician that, after suffering through a long succession of failures as an opposition figure, was appointed by the Putin administration in 2012 to a minor advisory post that is charged with advising the president on the creation of a Customs Union between Russia, Belarus and Kazakhstan.
Another factor that may be of relevance in evaluating the significance of Glazyev's statements is that he has recently been subjected to a series of very public humiliations as a result of events in Ukraine. First, in late 2013, Glazyev issued very public blackmail threats that were aimed at discouraging Ukrainians from joining the European Union. Glazyev's public threats were ignored, and in a rare show of unity, Ukrainian political parties almost unanimously joined forces to approve of the country's entry into the EU. Second, Glazyev was actively involved in the effort to get former President Viktor Yanukovich to back out of the EU agreement after it had been reached. Third, during the Ukrainian popular revolt that was sparked by Yanukovich's unpopular decision to back out of the EU agreement, Glazyev staunchly supported the embattled Ukrainian president and urged him to violently suppress protesters. Finally, during the revolt, Mr. Glazyev made various unsupported and hysterical-sounding public accusations that the USA was supplying Ukrainian rebels with massive amounts of money, arms and even training.
Thus, it may be useful to keep in mind that Sergei Glazyev is a man that carries quite a bit of personal and professional "baggage" when it comes the subject of Russia's and the US's involvement in Ukraine. Interestingly, the same news outlet that reported Glazyev's "threat" (RIA Novosti) also reported that high-level Kremlin sources were quick to distance Putin's government from Glazyev's statements, saying that his comments represented his personal views as an academic and were not made in his capacity as a presidential advisor.
What If Russia Dumped Its US Treasury Bonds?
There is little reason to believe that Glazyev's ideas regarding "financial warfare" are being seriously considered by the Kremlin. But what if they were? Many people fear that the US is vulnerable, as Glazyev suggests. If implemented, would the dumping of US Treasury bonds actually inflict any damage on the US and/or advance Russian interests? I will briefly outline some facts and important considerations:
1. Russia's holdings are not very significant. Contrary to what Glazyev's said and implied, Russia is a relatively minor player when it comes to US Treasury holdings. Russia is the US's 11th largest creditor, holding about $139 billion in US Treasuries as of December 2013.
2. Market impact temporary, at best, due to global arbitrage. If Russia dumped all of its US Treasuries into the market at once, US Treasury bond prices would fall and interest rates would rise modestly for only a few days, at most. The long-term impact would be minimal. Why? First, one must understand that the global market for bonds is worth significantly more than 100 trillion USD; Russia's holdings of US Treasury bonds barely represent more than 0.14% of the entire global market for all bonds. Furthermore, Russian US Treasury holdings represent an even smaller percentage of total global fixed income instruments. Any decline in the value of US Treasuries by Russian "dumping" would very quickly be reversed by global market arbitrage. How? Given that the relative credit fundamentals of the US would in no way be affected by Russia's politically motivated sales, traders would quickly act to profit from the temporary and unsustainable spread between US Treasuries and other global fixed income assets, bringing their relative valuations back into line.
For example, if the yield on US Treasury bonds rose significantly relative to Italian sovereign bonds or French corporate bonds, traders would sell those non-US securities and buy US Treasuries until spreads narrowed once again to reflect relative fundamentals. The Russians would essentially be shooting themselves in the foot by destroying wealth they have accumulated through oil sales, naively handing these riches to global bond traders that would be more than happy to disabuse the Russians.
Then, after the Russians sold US Treasuries at undervalued prices to very grateful bond traders, the Russians would have to figure out what to do with the US dollars they received in exchange (US Treasury bonds are sold in exchange for US dollars). Let's assume just for fun that the US dollar immediately fell in value due to speculation that the Russians would want to "dump" those dollars as soon as possible. Presumably, the Russians would want to get something of value in exchange for those dollars and not burn them or throw them down a proverbial garbage can (if they did, total dollars in circulation would actually fall and the value of the dollar might actually rise).
Assuming the Russians did not want to directly help stimulate the US economy by spending those dollars on US goods and services (how ironic that would be), Russians would have to use temporarily devalued dollars and bid up the value of other reserve assets such as Yen, German Bunds, gold or other such assets. Again, due to global arbitrage, the price of those assets would quickly fall after the Russians bid them up causing even further losses and humiliation for the Russians. Thus, Russia would essentially "screw itself" on both sides of the trade (sell side and buy side) while ultimately achieving no lasting impact on the value of US assets.
3. The US Fed could easily buy up bonds. The Fed could easily buy up any bonds the market was not able to fully absorb immediately. The purchase of all of Russia's bonds would only equal about 2 months worth of 2013 QE (65 billion per month). In the highly unlikely event that the Fed felt like it needed to purchase US Treasuries in the face of Russian sales to keep interest rates from temporary spiking, Fed action would merely increase their balance sheet by a negligible 1.5% in the worst case scenario where they were forced to buy 100% of those bonds. Indeed, a mere statement by the Fed that they stood ready to buy these bonds would probably be sufficient to support the prices of US Treasury bonds and to keep interest rates down.
4. The US Fed controls short-term interest rates and strongly influences long-term rates. Russian sales of short-term US Treasury bonds would have virtually zero impact on short-term interest rates in the US since the Fed essentially controls short-term interest rates via the Fed Funds system and other instruments. Since banks can borrow short-term funds at near zero in the interbank market, the yield on the short-term Treasury bonds sold by the Russians will quickly be bid down competitively to near zero by banks that are able to obtain funding at near zero. Furthermore, due to arbitrage effects and the carry-trade, long-term yields of any bonds the Russians sold would be very quickly bid down to previously prevailing levels.
5. Excess bank reserves could help mop up dumped bonds. US banks currently hold $2.5 trillion in excess reserves. - i.e. customer deposits that banks possess in excess of their mandatory liquidity requirements that banks choose to deposit at the US Fed and which currently earn only 0.25%. In theory, if US Treasury yields rose substantially due to Russian fire-sales, banks might be very happy to increase their profit margins by purchasing these bonds gifted to them by the Russians. Such a "mop up operation" could be fairly easily carried out by US banks in coordination with the Fed (which could guarantee duration-matched cheap funding for said purchases). Please note that due to the nature of the fractional reserve banking system, the existence of excess reserves is not a prerequisite for banks to buy massive amounts of undervalued Treasury bonds, nor will total reserves decline if this were to occur. However, the existence of mass quantities of excess reserves in the US financial system would make such an operation relatively more profitable for banks and easier to carry out than under normal circumstances.
6. Dumping US Treasuries could easily backfire. In a scenario in which severe economic sanctions were imposed on Russia, the Russian economy and that of some of its major trade and investment partners would be significantly disrupted. There is little doubt that the value of the Ruble, Russian stocks and other Russian financial assets would significantly decline in value relative to the US dollar. Furthermore, the resulting capital flight from Russia and its trade and investment partners could lead to a global "flight to safety" that would result in a strengthened USD, higher prices for US Treasury bonds and lower US interest rates. Finally, increased QE from the US Fed or the mere prospect of it could support the prices of risk assets in the US in the short term and ironically could even fuel them to even greater heights in the long term.
What if Russia Got China To Join Them In Dumping Treasuries?
Many analysts believe that Chinese interests are allied with those of Russia in their desire to undermine the role of the US Dollar as the world's reserve currency. Although this premise is far from certain, let us assume it to be true. The problem is that politically motivated fire-sales of US Treasury bonds would not be a viable way for China to achieve this objective.
Assume for a moment that the Chinese joined the Russians in dumping US Treasury bonds: Simply wash, rinse, repeat steps 1 through 6 above. China's US Treasury bond holdings are insignificant in proportion to the global market for bonds and fixed income assets, representing significantly less than 1.0% of the total. Therefore, any decrease in the price of US Treasury bonds or increase in yields caused by Chinese fire-sales would be transitory and modest due to global arbitrage of fixed income assets. Furthermore, any temporary inability of global markets to absorb Chinese bond sales in the short term could be easily handled by a combination of US Fed and/or US bank purchases as described above.
The Chinese would be even more foolish than the Russians if they were to implement such a fire-sale strategy. Indirectly, the Chinese would be doing the US a major favor by doing something that the US has been requesting that the Chinese do for a very long time: Sever the link of their currency to the USD. Divorcing the Yuan from the USD would have highly unpredictable consequences for the stability of the Chinese economy from both a trade and capital flow perspective. Fear of currency instability is precisely one of the reasons why the Chinese linked their currency to the USD in the first place and why they have strict capital controls that prohibit Chinese citizens from moving money out of China. By contrast, the US has very little to fear from a lower volume of bilateral trade and investment with China not only because this represents a very small portion of the US economy, but because the China-US economic relationship as it currently is structured may actually be a net negative for the US economy. Once any "finance war" wound down, the US would have an opportunity to restructure this particular relationship, demanding significant concessions from China before allowing any future access to US trade and capital markets.
Thus, assuming that the Chinese would ever be foolish enough to join the Russians in a politically motivated sale of US Treasury bonds, very little damage would be inflicted upon the US economy, financial markets or even the role of the USD in the world. To the contrary, Russia and China would become laughing stocks for having squandered away massive amounts of wealth and damaging their trade and financial competitiveness. Furthermore, the US and the USD would probably emerge strengthened in the long run via a more competitive trade position and a more balanced current account. Most importantly, the USD would emerge strengthened by the lesson learned through experience: The US dollar cannot be undermined by from foreign financial manipulation.
The mere threat that Russia or China could inflict major damage to the US economy by dumping US Treasury bonds has captured the imaginations of many individuals around the world - including some very intelligent people. For example, a distinguished analyst recently warned of this threat in a recent Seeking Alpha article and in response to reader questions. At one point, this particular analyst advised a reader that, "If they wanted to destroy us China would simply dump a trillion in US Treasuries on the market all at once. It would be that easy."
The truth is very nearly the opposite of what this analyst claims: If Russia or China were so incredibly foolish as to dump a trillion in US Treasuries on the market all at once, global bond traders, US banks and the US Fed will be there to very happily disabuse them of their accumulated riches. Such a move by the Russians and Chinese would go down as one of the most stupid strategic blunders in the history of international affairs. The mistake would be the product of a lack of understanding regarding how global fixed income and currency markets work. I advise investors to not make the same blunder by basing any part of their investment decisions on the prospect of such dystopian fantasies. In my 2014 Outlook to be published soon, I will focus on the issues that really matter for investors.