The Federal Reserve appears to be resuming its money-printing activities.
Earlier this month, it discreetly acquired a substantial $43.6 billion in U.S. Treasuries. This comprised $8.8 billion in 30-year Treasury bonds on May 8, alongside $20.4 billion in 3-year Treasury notes and $14.8 billion in 10-year Treasury notes purchased a few days prior.
What is happening? Shouldn’t the Fed be tightening its balance sheet instead of easing it?
After generating around $5 trillion in credit to address the coronavirus crisis, the Fed’s balance sheet peaked at over $8.9 trillion in April 2022. Since then, through a process known as quantitative tightening, it has gradually reduced its balance sheet to $6.709 trillion as of April 28. Yet, during May, this figure has slightly risen to over $6.713 trillion.
According to a May 7 statement from the Federal Open Market Committee, “The Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities.”
Nevertheless, if the Fed’s balance sheet is increasing instead of decreasing, isn’t it contradicting its policy declaration?
In truth, yes. Yet, in the complex nuances between right and wrong, there are technicalities at play. Effectively, the Fed is acquiring Treasuries quietly behind the scenes.
It is primarily reinvesting the proceeds from maturing bonds, a strategy consistent with policies described in the Fed’s recent implementation note.
However, let’s be honest: the Fed is buying bonds, which means its balance sheet is expanding. Thus, regardless of the technical explanations, we are witnessing a return to quantitative easing (QE).
Relying on the Kindness of Strangers
The Fed is effectively preparing to fulfill its role as the lender of last resort. Recently, the U.S. Treasury Department reported that foreign holdings of Treasuries reached a record $9.05 trillion in March, an increase of over $233 billion from $8.81 trillion in February.
However, these foreign Treasury holdings likely fell in April and May. You may remember that Trump’s tariffs prompted a Treasury sell-off in early April, which caused the yield on the 10-year note to spike from around 4 percent to nearly 4.6 percent.
Some of this sell-off certainly involved foreign investors. We will have to wait for updated Treasury Department data to confirm this.
What is clear is that as of March, China sold off $18.9 billion in Treasuries. Some of these funds were likely reinvested in gold. In fact, the People’s Bank of China (PBOC) recently increased gold import quotas, allowing local banks to exchange U.S. dollars directly for gold.
Clearly, the PBOC views diversifying away from the dollar as a wise move. This strategy has been ongoing since at least 2018, during which China has reduced its Treasury holdings from over $1.2 trillion to $765 billion, a decline of over 36 percent. Much of this selling has intensified since 2022.
This reduction has positioned China as the third-largest foreign holder of Treasuries, with the United Kingdom now second at $779 billion. Japan remains the largest holder, with nearly $1.13 trillion.
Nonetheless, depending solely on Japan to absorb all the U.S. government debt being issued is impractical. Japan has been financially strained for many years, relying on credit generated out of thin air to manage its debt, which is also funneled into U.S. Treasuries.
Worse than Greece
Japan’s cherry blossom season – sakura – is coming to an end, and so too is its overwhelming debt, which has persisted for nearly four decades.
Being the world’s largest foreign financier of the U.S. government demands ambition. However, Japan is now trying to tighten its fiscal policies while its economy contracts. This has garnered backlash against Prime Minister Shigeru Ishiba, a fiscal conservative, from a populace reliant on government stimulus.
What Ishiba is attempting to do is the exact opposite of President Trump’s proposed ‘Big, Beautiful Bill’, choosing not to fund tax cuts through new debt issuance. He stated to parliament:
“Our country’s fiscal situation is undoubtedly extremely poor, worse than Greece’s.”
To recall, Ishiba was alluding to the eurozone sovereign debt crisis initiated by Greece nearly 15 years ago, when Greece’s debt-to-GDP ratio was below 120 percent. In contrast, Japan’s current debt-to-GDP ratio hovers around 250 percent.
The key difference is that Japan finances its debt domestically, whereas in Greece, eight out of ten euros in debt were owed to foreign bondholders. When the time came, those foreign investors swiftly moved their capital elsewhere.
It appears that Japanese citizens have also grown skeptical about lending to their financially troubled government. On Tuesday, Japan faced one of the most dismal bond auctions in its history, with yields on the 30-year bond climbing to 3.11 percent, the highest since 1999.
Similarly, yields on U.S. government debt are also rising.
Warming Up the Printing Presses
Trump’s proposed ‘Big, Beautiful Bill’ is set to escalate the national debt by an additional $3.8 trillion on top of earlier projections. Instead of an anticipated increase of $22 trillion to $59 trillion over the next decade, the national debt could surge to nearly $63 trillion.
This development follows Moody’s recent downgrade of U.S. government debt to Aa1 from its highest rating of Aaa, citing a “deteriorating fiscal outlook.” Washington appears uninterested in reducing spending, balancing the budget, or repaying debt. How long until the U.S. government debt reaches junk status?
Mirroring Japan’s situation, investors demonstrated weak interest in a $16 billion auction of 20-year Treasury bonds on Wednesday, causing yields to rise to 5.12 percent and pushing 10-year Treasury note yields to approximately 4.6 percent.
George Saravelos from Deutsche Bank offered the following analysis:
“The most troubling aspect of the market reaction is the concurrent weakening of the dollar. This indicates a clear signal of a strike by foreign buyers against U.S. assets and the associated fiscal risks we’ve been warning of for some time. The core issue is that foreign investors are now unwilling to fund the U.S. twin deficits at current prices.”
If foreign investors, like those from China and Japan, are not reinvesting their dollars into U.S. Treasuries, what are they choosing instead?
Gold has drawn significant attention this year, recently trading around $3,300 per ounce. Bitcoin is also a notable alternative, enabling its price to spike above $110,000 this week.
However, these shifts are merely preliminary. The Fed’s covert QE measures are just starting to warm up the printing presses.
Later this year, when strained credit markets freeze like the Alaskan tundra, the Fed will once again be called upon as the lender of last resort. Jerome Powell may ultimately be compelled to run the printing presses at full capacity.
Based on our projections, we estimate that around $15 trillion in new QE liquidity – that is, credit created out of thin air – will be necessary to stabilize the banking system.
This means the dollar could face significant devaluation.
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Sincerely,
MN Gordon
for Economic Prism
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