Trump in bondage
A consensus is emerging that the biggest reason for Trump’s climb-down on tariffs last week was the reaction of the bond market. We haven’t heard the last of this issue.
For those who are not familiar with the bond market, here is how it works. The sale of Treasury bonds is how the US government borrows money. A bond’s value at maturity is fixed; its initial sale price is lower and is determined by supply and demand, with the difference between sale price and maturity value being the interest paid by the government to the investor. For example, if a bond is worth $100 at maturity, and you buy it for $95, then the $5 difference is the interest you get on the investment, effectively paid to you by the government. If you are less confident that the bond is a good investment, and you pay only $90, then your return is $10 when the bond matures, and the government is having to pay twice as much interest to borrow the money from you. In practice, the sale price of Treasury bonds is set by supply and demand and reflects investors’ collective level of confidence in the US economy at any given moment.
So any drop in bond prices automatically means a rise in the interest rate the government pays for borrowing money, which is considered a Bad Thing. Bondholders who are losing confidence can also sell their bonds to other investors, which naturally lowers the price at which the Treasury can sell new ones. This is considered a Very Bad Thing.
This is what started to happen last week as it really looked like Trump was going to stick with his demented tariffs this time and crash the US economy. In effect, bondholders lost confidence in their investment in the US economy and started trying to get out of it.
The reason this matters for the future of Trump’s befuddled trade and foreign policy is that huge quantities of US bonds are owned by foreign governments. Japan holds over a trillion dollars worth of them, China holds $760 billion, the UK holds $720 billion, Canada holds $380 billion, and many others also hold substantial amounts. Even by the standards of the US federal budget, these are very large amounts of money. And these governments have now learned that turmoil in the bond market can get Trump to back down even when nothing else can.
If a foreign government with large holdings of US bonds were to start selling them off, or even announced it was considering doing so, the impact on the US Treasury would likely be disastrous, depending on how many bonds the foreign government was proposing to dump. Other investors would likely follow suit. The price of new bonds sold by the Treasury would plummet and the interest cost of borrowing money would skyrocket. No president could ignore this. And foreign governments are perfectly capable of taking such actions for reasons other than purely investment confidence. If Trump does something that seriously pisses off, say, Japan — such as imposing another round of ridiculous tariffs, harassing Japanese companies that do business here, threatening to annex Godzilla, etc — then that trillion dollars worth of US bonds Japan holds will constitute a ready-made cudgel to force him to back down. Selling off bonds would lose them some of the return on their investment, of course, but they might well judge this an acceptable price to pay for squelching a US policy change that would do them greater harm, or simply asserting the principle that they refuse to be bullied. And even the mere threat to dump bonds might be enough.
The US is a very powerful country, economically and otherwise. But Trump thinks it’s an 800-pound gorilla that can intimidate every other country into submission if it just waves its fists around threateningly enough. It isn’t. Others have power too, in various forms. He seems to be gradually figuring that out.
There have been some rumors that the current prime minister of Canada —who has significant financial market expertise and contacts— orchestrated the attack on US debt that allegedly caused Mad King Donald to back off his literally insane “ liberation” tariffs. I am not as sure because if there is one principle which always guides the Mad King it is the grift. I suspect that the insider trading potential intrigued him more than fear of the bond market which he clearly does not understand anyway. Is anyone checking on what he grifted from the tech oligarchs in exchange for giving them relief from some of the tariffs?
I do have questions which I readily admit my limited knowledge of the bond markets can not answer. Specifically, the Mad King is making all kinds of noise about replacing Powell as Fed Chief because the Fed has hit pause on its lowering of interest rates— my understanding is that the Fed could do this through lowering the discount rate it charges banks for loans and buying treasuries on the open market thereby increasing demand and therefore the price and lowering the yield. My questions are first whether the Fed Chief can make these decisions without the other Board members going along? And more importantly absent really huge open market purchases, can the Fed force down interest rates through the discount window if there is a concerted effort by holders of US Treasuries to keep them high? I guess I am thinking long rates in particular because those inform the fixed 30 year mortgage rates. While these questions may seem academic, depending on the answers this may be just another example of Mad King Donald being his own worst enemy. Specifically as I write this the sell off in stocks, bonds and the dollar is accelerating apparently because of the Mad King’s saber rattling about interest rates. Did he graduate from Wharton or just sign up for classes?
Terry:
Rather than ramble through the role of the Fed Chair, the FED, and the Board of Governors and who is responsible to who, Wiki has a decent take on this. I need to think for a bit to answer the rest of your thoughts. The following is just a foundation,
The Board of Governors, a federal agency in Washington, D.C., is the main governing body of the Federal Reserve System, which is responsible for the nation’s monetary policy. While the Federal Reserve is largely independent of political pressure, it is accountable to Congress and the public.
Here’s a more detailed look:
Accountability:
The Board of Governors, as a federal agency, reports to and is directly accountable to Congress.
Independent Agency:
The Fed is designed to operate independently, meaning it’s not subject to direct political control from the executive branch or the legislature.
Congressional Oversight:
Despite its independence, the Fed is subject to congressional oversight and must operate within the framework of the nation’s monetary and fiscal policy objectives.
Board of Governors:
The Board is composed of seven governors, appointed by the President and confirmed by the Senate.
Federal Open Market Committee (FOMC):
The FOMC, which includes the Board of Governors and some Federal Reserve Bank presidents, is responsible for making key decisions about monetary policy.
Transparency:
The Fed is transparent and publishes its financial statements, FOMC meeting minutes, and a report on recent economic developments and its plans for monetary policy twice a year.
Terry:
Kind of tired yesterday so I was not answering much and all I gave was generalizations. WSJ article which will give some background. The rest of the story on The FED.
WSJ: “The Fed Board Agrees to Never Disagree”
“Still, it may surprise people to learn that not a single dissenting vote was cast by any member of the Fed’s Board of Governors throughout the eight monetary-policy meetings in 2020 and the three meetings held so far this year. The same is true for 2019, 2018, 2017, 2016, 2015 and 2014, covering Mr. Powell’s years as Fed chairman and the entire term of his predecessor, Janet Yellen (2014-18). No Fed governor cast a dissenting vote from the Fed chair at any monetary policy meeting held throughout that time.”
This kind of answers your question on how the FED works. And, Powell has been with the FED for years and maybe a couple of decades now.
I am not sure any one person or entity or group of billionaires can force interest rates in either direction. Do you know of any one person or a group of people who can accomplish this?
“promises the central bank will continue purchasing at least $120 billion of Treasury bonds and mortgage-backed securities every month (adding $1.44 trillion annually to the Fed’s balance sheet) until “we’ve made substantial further progress toward our goals.”
Same article as it is above.
With regard to Trump’s blathering which impacts the market. The FED can act in either direction to nullify his actions or words. If the market starts to fall, they can add liquidity. If it is too lose and inflation increases they can buy up bonds, etc. and tighten the market through increased interest rates and tightness of money (maybe wrong word there) through increasing interest rates.
Does this help?
Bill
Terry,
Before QE the Fed used open market operations to set the Fed Funds Rate (the interest rate banks charge each other for overnight loans to redistribute bank reserves within the banking system so all banks could maintain their 10% reserve requirements). QE flooded banks with reserves so the Fed now sets the FFR by paying interest on reserves and charging a slightly higher rate at the discount window.
Technically, the Fed could set the interest rate on government securities anywhere on the yield curve. The Fed has unlimited power to create bank reserves. It could just buy all government securities to create the demand needed to drive the interest rate down to where it wants. Basically taking away the power of the “bond vigilantes”, I am not saying this would or could cause other economic ramifications, I am just saying what the Fed is capable of doing.
Japan is a classic example. Its government debt is 250% of GDP but it’s 10 year treasury yields 1%. This is because its central bank bought enough bonds to keep the interest rate that low. The only problem I saw was the Yen lost some value when other countries raised rates and currency traders shifted out of the yen to seek higher yields elsewhere. Japan saw no more inflation than anywhere else in the world.