U.S. employment growth has recently accelerated, and the Federal Reserve is winding down its program of buying U.S. Treasuries with expectations of raising interest rates as soon as early next year. Yet the yield on the benchmark 10-year Treasury note has fallen from 3 percent at the end of 2013 to approximately 2.5 percent today. Where is the source of this conundrum? You can thank the Chinese.
Just when it seemed the Chinese were determined to diversify their foreign-exchange holdings away from U.S. government bonds, they have returned to the U.S. Treasury market and are buying with a vengeance. According to the U.S. Treasury, during the first five months of 2014, China boosted its holdings of Treasury debt by $107 billion. This represents the fastest pace of Chinese buying since records began more than three decades ago and easily surpasses the $81 billion of debt purchased by China for all of 2013.
Why the reemergence of China in the U.S. debt market on such a scale? First and foremost, the Chinese have little choice but to keep purchasing U.S. Treasuries given the dearth of investment choices elsewhere. Nothing can come close to matching the size and liquidity of the U.S. sovereign debt market. And with the Chinese bilateral trade surplus with the U.S. running at record levels in the first five months of the year, the authorities need a secure place to invest all those dollars. Secondly, with economic growth slowing recently—particularly from a deceleration in Chinese net exports—a weaker yuan contributes to the competitiveness of their exports.
The benefits of lower bond yields for the U.S. are obvious. Interest rates on everything from mortgages, corporate debt, and credit cards are reduced (or are lower than they otherwise would be), motoring up the domestic economy. The benefit for the Chinese is having a relatively safe and highly liquid place to park their roughly $1.3 trillion of U.S. debt, or about 11 percent of the $12 trillion U.S. Treasury market.
But many of the costs from lower yields are hidden or difficult to predict. For example, lower bonds yields translate into lower income for bondholders (the current yield on the five-year Treasury is only 1.66 percent). This forces investors to search the globe for higher yielding assets, possibly fueling asset bubbles. (U.S. equities and junk bonds, for example, look historically pricey.)
The Chinese, in turn, are constantly purchasing U.S. dollars in exchange for yuan (to keep their exchange rate from appreciating). This results in a rapid growth in their monetary base which can eventually translate into higher domestic inflation as it did before the global economic crisis.
Looking longer term, the costs of this relationship will eventually exceed the benefits. Loose money and low interest rates are never sustainable. For now, however, both sides seem content with the current arrangement.
