Though wage inflation came in nice and cool on Friday, the following chart illustrates why upward pressure on long-term interest rates will continue. We updated our Who’s Funding The U.S. Budget Deficit chart with the just released Flow of Funds data.
The Q4 2017 data show the Rest of World (ROW), primarily foreign central banks, and the Fed were net sellers of Treasury securities to the tune $319 billion on a seasonally adjusted annual basis. This could be the reason why interest rates have spiked over the past three months.
Note the Fed and other central banks have financed most of the U.S. budget deficit over the past ten years and foreign central banks were the largest financier of the Treasury leading up to the credit crisis. The main factor contributing to Greenspan’s bond market conundrum.
We know with certainty, unless they reverse course, the Fed is going to big net seller over the next few years as they runoff their balance sheet. It is unclear as to what foreigners will do, but if they continue to reduce holdings or significantly cut back on their net Treasury purchases, real interest rates are heading north. Probably much quicker than the market expects.
Ironically, President Trump’s aversion for trade deficits could lead to higher interest rates in the U.S. as foreign central banks have less dollars to recycle back in the domestic bond market.
Keep it on your radar.