Outstanding U.S. public debt increased $1.4 trillion over the past year. Who were the buyers? The Federal Reserve’s Quantitative Easing (QE) policy gobbled up a net $1 trillion of Treasuries, while foreign buyers snapped up nearly $500 billion.
Why do 10-year Treasuries only have a nominal yield of approximately 1.6% while inflation rages ahead by 5.4% year-over-year?
That anomaly may be due to the Federal Reserve effectively purchasing 70% of the increase in Treasury debt over the past year. Fed leaders don’t care that bond yield is approximately a negative 4%. Fed leaders have been attempting to fix the bond yield low as it appears to be what the White House and Treasury secretary want Federal Reserve leaders to do.
Most of the foreign buyers are in developed economies where their equivalent 10-year yield is either negative or slightly positive. At a 1.6% yield, the 10-year U.S. Treasury looks attractive to them so foreigners drink the Kool-Aid.
The Federal Reserve has been on a more than one year Treasury buying spree. Quantitative easing started in 2008 and Fed leaders have added nearly a net $5 trillion of Treasures to their balance sheet since then. Also $2.5 trillion of Mortgage Backed Securities has been added to their balance sheet.
Currently the Federal Reserve holds 25% of the outstanding public debt while the foreign sector holds 34%. Combined, that is nearly 60% of outstanding Treasury debt.
The 10-year yield will remain well below the rate of inflation as long as the Federal Reserve continues to be the marginal buyer of Treasuries. The Biden team, including the Treasury Secretary, decided to load as much additional Federal debt as possible onto the economy during Biden’s initial year in office. That required the Federal Reserve to be the major buyer to keep bond yields low.
Holding bond yields down has effectively meant a major mispricing of both financial and real assets. One would expect bond yields to be somewhat close to inflation’s pace. A 10-year Treasury yield at 3.5% or 4% would not be unreasonable. Equity and bond prices would be significantly lower at that bond yield as would real estate prices.
QE has accommodated companies raising their selling prices and generating healthy profits, which has resulted in pricey equity values. QE is allowing for price increases across the economy.
Fed Chair Jerome Powell wants to be reappointed, so he was ready to continue QE in a hot economy, even when it became clear in early 2021 that QE was no longer needed. Powell knows he is surrounded by other Federal Reserve members who would be willing to step into his role and continue QE if he didn’t.
Continuing QE in a hot economy means that the Fed accommodated the price pressures in this economy, resulting in consumer-price inflation of over 5%. Fed leaders have pumped in over $4 trillion since February 2020.
The time lags of monetary policy are long and variable, which means the $4 trillion injected will be accommodating price pressures for perhaps several years.
Fed leaders talk about starting to taper late this year and plan to wind down their QE program in mid-2022. If that timeline is met, it means the central bank won’t complete buying Treasuries unit mid-2022. While that could happen, the Fed may find a reason to continue QE, especially if Treasury yields march higher during tapering.
Mike Cosgrove, principal at Econoclast, a Dallas-based capital markets firm, is a professor at the University of Dallas.
