Surging US Treasury yields are the main driver of global markets, depressing stock prices, pushing up the US dollar exchange rate, and threatening homebuilding and other rate-dependent economic activity in the United States. As rates rise, moreover, the US Treasury deficit – already above 6% of GDP – will increase. Interest payments on the federal debt rose to $1 trillion from $400 billion in 2021, adding to the blowout federal borrowing requirement of $1.8 trillion.
Foreign central banks meanwhile have cut their holdings of US government debt, adding to upward pressure on yields – by a painful 0.8 percentage points, according to my calculation. The seizure of Russian foreign exchange reserves in 2022 led central banks to shift out of dollar assets. The reserve seizure probably did more damage to the US economy than to Russia’s.
The Federal Reserve caused most of the rate surge by raising the rate at which it charges banks for overnight money, to be sure. But a significant increment in the so-called real yield of Treasury bonds – in this case, the interest rate on inflation-indexed Treasuries (TIPS) – is due to reduced purchases of US debt by foreign central banks. Roughly 80 basis points (8/10ths of a percentage point) are explained by reduced foreign central bank holdings of US government debt.
Foreign central banks, including those of China, India, Saudi Arabia, and Turkey, began shifting their foreign exchange reserves into gold and out of Treasuries after the US and its allies seized half of Russia’s $600 billion in foreign exchange reserves in early 2022, following Russia’s invasion of Ukraine.
The chart below shows how big the impact of foreign central bank sales of US government debt has been.
The red line shows the six-week change in foreign central bank holdings of Treasuries, as reported by the Fed. The blue line shows the portion of the yield of 10-year TIPS that is not explained by changes in the federal funds rate (the overnight rate the Fed charges to banks). As of January 1, 10-year TIPS yields were 80 basis points higher than predicted by the federal funds rate (the blue line, again, is the change in the TIPS yield that is not explained by the federal funds rate). Econometric tests show that the relationship between the two variables is significant at the 95% confidence level.
While the US Treasury’s borrowing requirement has risen sharply, foreign central bank holdings of US Treasuries have declined. This stands in sharp contrast to the 2007-2012 period (including the World Financial Crisis), when the Treasury stepped in to support the banking system with a (then) unprecedented bailout of $800 billion. Foreign central banks, notably including China, stepped in to support the Treasury, doubling their holdings of US government debt to $4 trillion from $2 trillion in 2007. During the Covid crisis of 2020, by contrast, foreign central banks (notably including China) reduced their holdings of Treasuries.
This has had a substantial and measurable impact on US Treasury yields.
A comparison of leads and lags shows clearly that changes in foreign central bank holdings of Treasuries lead changes in the TIPS yield (again, we are looking at changes not predicted by the federal funds rate). In the chart below, each bar shows the correlation between present and lagged values of the two variables at weekly intervals. With a 5-week lag, for example, the lagged value of changes in foreign central bank holdings of Treasuries shows a -0.6 correlation with that week’s TIPS yield. The cross-correlogram indicates that changes in foreign central bank holdings predict future TIPS yields, rather than vice-versa.
It also explains the de-coupling of the gold price from the real yield on US Treasuries. Gold and TIPS yields traded in tandem for the 15 years from 2007 to 2022. Both assets play a similar portfolio role: They offer a form of insurance against unexpected inflation and dollar depreciation. The difference is that Treasury securities can be seized by the US government, as in the case of Russia, while gold in a central bank’s vault can’t.
After March 2022, gold rose sharply despite the rise in TIPS yields. With all the world’s major Western economies running large deficits, the stability of government debt is in doubt, and the value of gold as a hedge against currency depreciation rises.
Like other sanctions against Russian trade, Washington’s seizure of the Russian reserve backfired. It destroyed trust in the foundational asset of the US dollar reserve system, namely the debt of the US Treasury, and raised America’s borrowing cost just as the Treasury’s borrowing requirements exploded.
