At the present time, the United States has $22 trillion of outstanding government debt. Over each of the next five years, the national deficit is expected to be around $1 trillion annually. Additional deficits and existing government debt maturities make it very important that investors maintain demand for U.S. Treasuries.
Since the financial crisis in 2008, outside of the Federal Reserve which owns $2.46 trillion of U.S. Treasuries, China has become the largest single holder of U.S. Treasury securities at $1.13 trillion. As the trade war between the U.S. and China continues, speculation persists that China could sell most or even all of its Treasury holdings in retaliation for the U.S. tariffs.
We believe that China dumping its Treasury holdings would be a last resort measure. Over the years, China has accumulated over $3 trillion of foreign currency reserves that need to remain safe. The safest and most liquid investments for these reserves are in developed country government bonds. Yields on U.S. Treasuries are the highest of any developed country, offering China the biggest return on these investments.
Initial reaction to the thought of China selling its U.S. Treasuries would lead us to believe that Treasury yields would spike on the news. While this is certainly a possibility, it is also very reasonable to conclude that U.S. Treasury yields could then ultimately actually fall even after an initial knee-jerk spike. The reason for a decline in yields would be increased concerns that the trade war between the U.S. and China could drag on for longer than anticipated, potentially leading to a slowdown in global growth or even a global recession.
The good news is even if China were to stop purchasing U.S. Treasuries and reduce its holdings, we believe there will be enough demand by other investors to pick up the slack. Of the $22 trillion of outstanding U.S. Treasuries, $5.8 trillion, or 27%, is intragovernmental debt, owned by U.S. federal agencies such as Social Security, Federal Retirement Funds and Medicare. The remaining $16 trillion of debt is owned by public holders including foreign investors and governments (40%), pensions and local governments (10%), the Federal Reserve (16%) and mutual funds/banks (18%).
In the unlikely scenario that investors decide not to pick up the slack from China’s reduced holdings, we believe there is a very high likelihood that the Federal Reserve would step in and resume purchasing U.S. Treasuries to combat a significant spike in yields. Every day the trade war drags on, the likelihood increases that China will sell U.S. Treasuries in retaliation. While there is certainly reason to be concerned over this tactic, overall, we believe the impact on yields would be minimal. We see no reason to panic over this threat and would not look to significantly reduce duration in bond portfolios as a result.