“Will there be a mismatch between what the U.S. wants to sell (Treasuries) and what the world wants to buy?”
Brad Setser asks the above question in his “Follow the Money” post How Will the U.S. Fund its Twin Deficits?
In the past few years, the U.S. Treasury has needed to, on net, raise about three percent of U.S. GDP from the market to fund the budget deficit. A portion of the deficit has been funded with short-term debt, so funding deficits of that size have required roughly 2 percent of GDP per year in (net) issuance of Treasury bonds and notes.
The external deficit could be financed by selling off equity, but, by and large, it hasn’t been—U.S. purchases of foreign equity and foreign purchases of U.S. equity have tended to largely offset, so the bulk of the current account deficit has been financed through the sale of bonds to the world.
Since 2014 the inflow has been into Agencies and corporate bonds. Obviously, the question of who is going to buy all the bonds the Treasury will issue has gained additional prominence recently.
The fiscal deficit is rising toward 5.5 percent or so of GDP, which implies that the Treasury will need to sell about 4 percent of GDP of bonds (on net) a year—not the roughly 2 percent of GDP it now sells. These numbers assume—based on some work that Goldman Sachs has done—that increased bill issuance can cover around 1.5 percentage points of GDP of the annual funding need, so “note” and “bond” issuance will lag the headline fiscal deficit. ?
On the other hand, the Fed will be cutting back its Treasury portfolio at an annualized pace of $90 billion a quarter, or a bit under 2 percent of GDP once the roll-off is fully phased in. The market consequently will likely need to absorb over 5 percent of GDP of longer-dated Treasury issuance—a real step up from the current level.
What Will Give?
Setser mentions four possibilities.