Wall Street Banks Cut Holdings of U.S. Debt

Jan 11, 2011 | Budgets & Projections

Wall Street banks have been drastically cutting their holdings of U.S. Treasuries, according to Bloomberg News. According to most analysts, this is a reaction to expectations of a stronger economy, which is leading banks to invest more heavily in private equities as opposed to Government bonds. While this is certainly good news, it does highlight the risk that U.S. Treasury bonds could cease to remain “the finest horse in the glue factory,” especially if the private sector outlook continues to improve as the government goes deeper and deeper into debt.

Bloomberg noted that the 18 primary dealers that trade directly with the Federal Reserve have been cutting their holdings of Treasuries at the fastest rate since 2004. Net holdings among these banks fell from $81.3 billion on November 24 (the most since June 2009) to just $2.3 billion on December 29. As the article stated:

"Government bonds lost their allure as stocks rose, corporate financing conditions eased, expectations for inflation increased and the dollar strengthened."

The prospect of faster growth is good news all around. Not only will faster growth reduce unemployment and increase wages, but it will increase the amount of revenue coming into Treasury and it will improve the denominator in the debt-to-GDP equation. Still, reduced demand for Treasury bonds could force up interest rates, increasing our interest payments and, ultimately, the deficit. As long as these interest rates are being driven up by increased demand in private stock, the benefits of improved growth will outweigh the dampening effect of higher government interest payments.

However, if interest rates go up as a result of falling demand for government bonds – on the belief that the United States government is at risk of fiscal insolvency – the news is all bad. In that case, not only will government interest payments go up, but economy-wide interest rates will rise and crowd out private investment. This scenario could also lead us toward a fiscal crisis.

As seen in the Treasury yield curve, rates have been increasing over the past few months, which could indicate either an improving economy or increased fears over U.S. debt. It appears, for now at least, that the first is true - thankfully.

[chart:2478]

Let's hope we never get to the point where markets actually force us to make immediate changes to our spending and tax levels. It is always better for us to make our own adjustments well before a lack of market demand for government debt threatens us with the prospect of little to no external financing.  

So while news that market demand for Treasuries is falling due to improved prospects in stock markets (switching low-risk, low-return investments in exchange for higher returns elsewhere) demand for Treasuries could also fall sharply if investors think the U.S. is just too risky (switching high-risk investments for safe-returns elsewhere).