Odd Lots - This Is What's Actually Happening When The Government Auctions Bonds

Episode Date: July 9, 2018

Thanks to the tax cuts, the U.S. deficit is expected to surge again. And of course that's brought greater attention to the government's semi-regular Treasury auctions. But the government borrowing money isn't like a household borrowing money, and analogies between the two can be misleading. On this week's Odd Lots podcast, we speak to Brian Romanchuk, the author of BondEconomics.com and a long time financial industry veteran, about what's actually happening when the government taps the debt market. See omnystudio.com/listener for privacy information.

You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and data to keep you informed. Yes, there are other products like this from a variety of news organizations. But they usually rerun their radio newscasts throughout the day. That's not what we do. We create customized episodes that can only be heard on Bloomberg NewsNow.

And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify or anywhere you listen. Hello and welcome to another episode of the Outlots podcast.

I'm Joe Wise and Paul. And I'm Tracy Allaway. Tracy, there's a lot of talk about the deficit and the debt these days. For a long time, maybe that sort of story went away. But with the tax cuts and people wondering when the next downturn comes back, it really feels like government debt is a big story again. Yeah, absolutely. We've seen lots of talk about bond vigilantes staging a comeback. We've seen lots of forecasts from various analysts about just how big the U.S. deficit is going to get, given Trump's

propensity to borrow and also enact fiscal stimulus. There is a lot to discuss when it comes to the world of U.S. government debt nowadays. There absolutely is. And I think one of the things that's always driven me crazy. I think both of us crazy is the sort of naive view about how people talk about government debt, particularly U.S. government debt. There's this view often that sort of sees the government as just sort of a typical borrower, like a household or a person trying to borrow money to buy a car. And as we know, it doesn't really work that way. And that can really lead people to a lot of false assumptions, like about what interest rates are going to do. and what the market is going to do.

So I know you say it's a naive viewpoint, but I'm going to make a confession here and say that, you know, in my head, I understand the point that the U.S. government is not the same as, you know, the head of a household who's totting up their income versus their expenditure every month. But deep down in my gut,

I have always been uncomfortable with the notion that the U.S. can borrow extraordinary amounts of money and not have major, major impacts. So I'm actually really excited to dig into this subject because hopefully it'll make me feel better. Yeah, I agree. There's a non-intuitiveness about it. And even if you say like, oh, you know,

the U.S. creates its own money and borrowing for the government is not the same as it is with the household, I know what you're saying about you're like, well, yeah, surely we must be still getting close to some risk. So hopefully we can maybe, use this episode to get a little more comfortable with thinking about what government debt means in a slightly different manner. Yeah, that sounds great. Great. So today I'm very excited to welcome

to the podcast, Brian Roman Chuck. He is the author of the Bond Economics blog. He's a financial consultant. He's written about the bond market and what really happens. He's a veteran of the financial industry. And he is going to help us understand what's really happening when the government issues all this debt, which of course is a major theme of the news these days. Ryan Romancechuk, thank you for joining us on Oddlots. Let's start with the big question. When someone or a bank or an investor is buying a government bond, what does it actually happen? On paper, it does look similar to buying another bond.

You know, you transfer money to someone in exchange for a security, which has accused. So there is some similarity. You're going through the same settlement process and you know, you end up with rights. If you buy it 10 million, you know, once you have control of it, then you get, you know, a certain contractual payments, you know, up until the bond maturity. And any bond, well, standard bonds all have the same sort of structure. We'll give you a certain coupon and then there's a final principal payment. So the cash flow perspective, all bonds are similar in that sense. So at the risk of using a terrible cliche, you know, you're getting this IOU from the government, essentially. It comes with a coupon, which kind of informs the yields that you're going to get. Most people, when they think of U.S. government debt, they're going to think of treasuries, obviously, and they're going to think of the U.S. Treasury. Is it the U.S. Treasury who is actually selling these things, or are there other entities involved? The U.S. Treasury, they auction it. As a Canadian, I forgot the exact details, but it's done.

There's an auction, and the auction is, they say there's going to be a certain number of bonds, and then at a certain maturity, and then they line up bidders, and most of the bidding comes from, they're called the primary dealers. It's mainly banks, but they're security dealers that deal with the Fed, and they're obligated to bid, and they do most of the bidding. Other entities, you can do a non-competitive bid, but that's usually a small part of the market. And once all the bids come in, you don't give a price. You just say, I want to buy it at this yield.

And then once all the bids come in, you say the lower yield is essentially a higher price. The lowest yields to buy all the bonds win the auction, and they get the bonds delivered. to them. And then usually the primary dealers sell them on to other, you know, investors like pension funds, people like us in the secondary market. Now, one of the things that we talked about this in the intro is that we have to dispel the myth that the U.S. is just like any other private sector borrower. And so we've established that the bonds on paper look the same. It looks like any other corporate bond or a loan that might get turned into a bond-like instrument. But it's fundamentally different. And the key difference is the source of funds. So explain to us structurally

why the U.S. is a different kind of borrower. Well, the key difference. And, you know, for the U.S., the U.S. controls its central bank. And as the horrible counter example is a place like the euro area where the countries don't control their central bank. And because ultimately, all these bonds say we're paying you U.S. dollars and the U.S. dollar is the liability of the U.S. Federal Reserve, and the U.S. Federal Reserve, the Fed, is owned by the Treasury. So that gives you the one big picture difference than any other borrower. And the other issue is for the government, their main concern, they're more concerned a bit about the macro consequences of spending and not so much the financial.

A smaller borough, an individual bank, no matter of big they might be, aren't really worried about the effect of their spending on the overall economy. And that is a key difference in understanding, well, you know, why are they different? Okay, so I'm going to let my gut talk now, which is probably a mistake, but here we go. So why can't the U.S. government just borrow as much as it wants, you know, enormous amounts of money? What are the negative effects that are going to happen if it does that? It's not the borrowing per se. That's the problem. Because you would say if there's a problem, it would be on the spending.

Because you say, what is the government buying? I mean, maybe they're buying good things. Maybe it's bad things. but one can always debate, you know, what the spend money on. But from a macro perspective, what the worry is, if the government starts buying too much stuff, they drive up the price of everything, i.e. there's inflation. And they spend a lot and causes inflation. But the borrowing is the flip side of the spending.

Because if they're spending more than is coming in from taxes, there's a fiscal. deficit. And the way that that's matched in practice is, well, that that's covered by borrowing. And so the borrowing comes with the spending. And so it's a mistake to worry about the borrowing and say, what is the government spending on? So this is the part that I think people really have a hard time, is why we shouldn't worry about the borrowing. Because in theory, you would think, okay, people are buying government debt and the government debt just keeps going higher and higher and that maybe one day these buyers will say, whoa, you guys are spending so much money, you're never going to be able to pay it back. Tax revenues aren't coming anywhere close.

I'm not going to buy government debt anymore. So this issue, I think, is still what we need to address, which is why is that not a risk that one day lenders just won't show up? Well, I mean, that is a worry, and it was anyone as being around the markets, that was a worry. I started in finance 98 about Japan, and even in 1998, that was a big worry, and that continued. And it was called the Widowmaker Trade. People said, well, Japan's going to default within months, and they shorted Japanese government bonds, and they kept losing money. By now, people have largely given up on that.

but the reason why the governments can get away with this generally is their spending creates the money that then is sucked back in by the bond auction. It's a circular flow. And this is why, yes, there's a demand for, like, you know, there's a demand for borrowing for the government, at the same time they're supplying money that then is recirculated back into the bond market. I think this is just sort of the really key point here, and I want to sort of really dive into this. So let's say the government wants to spend $10 billion more on some new aircraft program for the military.

That $10 billion that they spend, I think as you're saying, winds up in the bank account of some private defense contractor. And then that money in the bank ends up going, perhaps a small. circuitous route ends up back being invested in government bombs. Do I have that right? Yeah, that's basically it. I mean, now it's a bit more common because you have excess reserves. But what happens is if the government sends a defense contractor $10 billion, they'll have a $10 billion deposit on the bank. The bank in return, they get $10 billion transferred to them from the Fed and they have $10 billion as a deposit the Fed. I mean, these are reserves. you know, because the Federal Reserve is a bank.

And so, but the bank doesn't really want. I mean, independent of what the customer might want, that $10 billion is sitting in the bank account because it'll have expenses. But the bank itself, what's it going to do with the $10 billion? It has an asset on the balance sheet, which is a deposit at the Fed, which is a low-risk asset, which pays, you know, used to pay nothing, but now very little.

And say, we want to do something else with this asset on our balance sheet. And so they then go out and say, we want something, it gives a higher return. And essentially, how the loop gets closed is, hey, there's, you know, treasury bonds. We buy them. They should have an expected return higher than leaving the money on deposit on the Fed. And so the bank will go out and buy the treasury bonds in the auction because otherwise they're stuck with the deposit the Fed that's paying them very little. June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world.

Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets. From corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars and policy experts to break down what the rulings really mean. We do this every weekday, then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen. On the East Coast, listen as you start your day, and on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso.

Subscribe today wherever you get your podcast. So, Brian, just on the the money creation point, when it comes to the U.S.'s government borrowing, a lot of people will often point to the special privilege that America enjoys by virtue of the fact that the U.S. dollar is the world's reserve currency. In other words, other countries need it. And so they're going to keep buying U.S. treasuries in order to stabilize their own accounts and their own currencies and things like that. How much does that play into the ability of the U.S. government to keep borrowing, And, you know, you mentioned the Japan example. People have been worried about Japanese government debt for ages.

The yen certainly is not the world's reserve currency. So how come they're able to do that as well as the U.S.? The reserve currency, when you had a fixed exchange rate regime, it did make a difference in Bretton Woods, but it's been a long time. Canada, Australia, United Kingdom, I mean, they're not really reserve currencies, but they're pretty much in the same position as the U.S. From the perspective, economic perspective, let's say you have an Asian central bank, they look, as far as the U.S. domestic economy is concerned, they're a private sector borough. And they have the same choices as any other private sector investor.

What do we do with our U.S. dollar assets? And, you know, they could hold cash. They could leave money on deposit the bank, or we could buy a treasury. So they don't really have a choice. If they want to hold U.S. dollar reserves, they have to do something with it. And by convention, you know, they don't run around. It's frowned upon for central banks to run around and buy private sector assets like equities. There's a little bit of dabbling in equity markets, but that's only a tiny fraction.

They keep their money in fixed income assets and they want safe ones. I mean, they don't, because they might need to call on their reserves if, their currency is under attack, and then, you know, they don't want a private debt that's in the process of defaulting when they need liquidity. And so by default, they tend to end the treasury. So it's a two-way street, and to a certain extent, they're trapped into the treasury holdings as well. And in theory, if a foreign holder of dollars, let's say they did want to buy equities instead treasuries just for whatever reason, that would create some new holder of those dollars at some other bank. And so it's not like the dollars would just sort of disappear. It would be

yet another buyer somewhere else would show up who would have dollars on reserve at a bank and then would theoretically go into treasuries. Yeah, it's, for every buyer there's a seller and scare stories often revolve around forgetting that, that basic principle. Yeah, there's someone with the dollars has to buy. So, you know, the pricing can change, of course. I mean, that's the thing. If you're worried about pricing, yes, treasury prices would go down relative to other things, but the flows will still cancel out. So how come Japan can borrow enormous amounts of money? Well, it's the same issue. There's excess yen. They're creating yen. And I haven't looked at the latest data, but they're roughly in trade balance. So it's mainly,

domestic owners. Very few people want to go in and buy Japanese bonds. I mean, people buy Japanese equities, but not bonds. People just think they're ridiculous, although now maybe not so much. But the, you know, the yen is somewhere in the system, and Japanese banks basically have no choice, but they buy the bonds, although recently it's been the Bank of Japan. They've basically bought most of them up, and now the banks just have to deposit. It's at the Bank of Japan. But in the end, it's just that if they spend the yen end up in the system and the yen has to go somewhere and that drain is the Japanese government bond market. So doesn't matter if the buyers of your debt are more domestic or more foreign.

Is one group better than the other? If you're borrowing in your own currency. I mean, this is very different. If you're like an emerging market borrowing in another country's currency, then you're, you're, you're in a emerging market borrowing in another country's currency. then you have to be very worried about foreign holders or if you have a fixed exchange rate peg and you see that in the euro area. Then you like domestic things, domestic buyers of your debt because you have more control over things. But for a floating currency sovereign, if you have a lot of foreign buyers of your debt, it means you're running big current account deficits. And is that good, is that bad?

you know, the U.S., their industrial strategy since the end of World War II has been running trade deficits with strategic partners. And, you know, the U.S. has costs and there's benefits for the U.S. Right now, people are focusing on the cost, but there's, there are benefits the way the U.S. runs a system. But the foreign buyers, in theory, they could panic more, but at the same time, they don't want to lose money. You know, it's very, you know, if you're a big holder of bull,

bonds. You can sell in a panic and you can lose a lot of money. I mean, I work for a firm, which was large, and if we wanted to, we could lose a lot of money very quickly by selling our assets and a panic. Well, that's not our job. Your job is not to lose money very quickly, so you generally avoid doing stuff like that. So that's why on paper, the foreign investors could get spooked more, but they still want to make money. So it's not clear that they're much different than domestic investors in that respect. Okay, so we've established that for the U.S. Credit risk isn't really a thing because the dollars that come to buy treasuries come from the spending. And we've also established that you don't even need to be a reserve currency for this phenomenon to exist because it's in Japan, which has lots of debt, in Canada, which is not anyone's a reserve currency, Australia and New Zealand.

Then the obvious question is, why can't all countries do this? And so people think to the extreme example of a country like Venezuela and the debt they have, why can't they just spend and keep a stable currency and a stable market? I'm not an emerging market person, but there's policy differences between Venezuela and the U.S. coming down to the strength of the tax system. The IRS, as everyone knows, is a powerful organization, and it has the income tax has the ability of damping economic activity, and so it controls inflation better than in the country with a weaker tax system. And my pet theory is that the difference comes down to the effectiveness of the tax regime for inflation control. I mean, that's a major difference.

But there is also a question of what is produced. If you're dependent on foreign imports for a lot of goods, then your domestic inflation is driven by your exchange rate, whereas the U.S. is largely a closed economy, I mean, relatively a closed economy when compared to other countries, and changes in the exchange rate don't have much of an effect on prices. So you can largely ignore. I mean, if the U.S. dollar falls 10%, it's not really noticeable in domestic prices.

So with all the talk of the U.S. deficit growing and the U.S. government borrowing more under the current administration, lots of auctions happening, not just of longer-term treasuries, but also T-bills, what are you looking out for when it comes to U.S. auctions to sort of gauge the health of the market and to determine how successful an auction is? In terms of success of auctions, that was something that, that was a technical detail I didn't worry about. But the overall trend,

it's going to be, are these deficits going to cause rapid growth? If you're worried about the pricing, which is the usual worry, what's going to happen to bond yields? If the government's spending a lot, it'll have inflationary pressure, and that's going to force the Fed to hike rate.

And that, you know, from a bond market, you know, pricing perspective, that's your worry is that the Fed gets more aggressive with rate hikes and pushes up bond yield. That's going to be, you know, much, much more of a concern than the just supply demand. So the big picture, and if we sort of wrap it all up here, is that it's not the borrowing per se. It's not the gap between the government's expenditures and its revenues via taxes. It's really about the capacity of the economy to absorb all that spending. That sort of is what theoretically would drive inflation. And then the link between inflation and what the Fed does, that would sort of be what ultimately determines what long-term rates are going to do.

And then that, you know, once you answer that, then you can decide whether it makes sense to buy a bond or not. Yeah, that's basically it. And the question is, it's not just a simple difference. I mean, this is the question with the tax cuts. How much of a stimulus impact have they had? I mean, there's been not much of an inflationary impact. It's been good for the stock market.

There's a lot of money got funneled into stock buybacks. But by itself, that isn't putting inflationary pressure on the economy. So there's a big difference between what the deficit is doing and the effect on the economy. And it's hard to model. I mean, it's not an easy thing to say what the effect on the economy is going to be. Presumably, there's a big inflationary difference between, say, rich people getting a tax cut versus a policy that said everybody in the country gets a new bicycle, even if it on a dollar amount, it costs the same. That's presumably the difference. I mean, you might have political, this is where sort of politics comes in. People might disagree, but that's certainly my view that

you hand the tax cut to the bottom 20% or you buy stuff much more inflationary than a capital gains tax cut. Brian Romanchuk, thank you very much. Very interesting conversation. And I think these sort of this guts of how this all works out very rarely discussed when people talk about the bond market. So appreciate you coming up. Thanks. Thanks. It's nice to be on.

So Tracy, are you convinced that it's not a big existential threat? for the government to run what's on paper, very large deficits? I feel like I have a better intellectual grasp of what's going on and the idea that, you know, borrowing from the government isn't actually about moving money from one entity to the other. It's actually about creating money. I get that. But I got to be honest, Joe, part of me is still thinking there have to be some consequences. I think there's two things that I think we're really used for.

there. So one is obviously just really understanding this idea of the closed loop, this idea that money never leaves the banking system. Because, I mean, for one thing, we know that all money is digital, basically. And so it can't just disappear. And so if it's going to stay in a bank, and a bank will ultimately put it into treasuries, even if it causes many hop skips in a jump. I also think that point that he made about the strength of institutions is really important. and this idea that it's not necessarily the borrowing per se that you want to worry about, but if you want to look at sort of institutional degradation in developed economies, you could certainly point to a lot of things these days.

Right. And we've had this discussion at one time or another about how when you're ramping up government borrowing, you're really making big decisions about what you're going to spend that borrowing on. And those are value decisions that are being made. The other thing I thought was interesting was when he sort of flipped it on his head and said, you don't necessarily need to worry about the borrowing, but about the capacity of the economy to absorb the spending. And that's something that, you know, you've seen the Federal Reserve make noises about it, this notion that we are running close to full capacity at this point and what impact is a whole bunch of fiscal stimulus actually going to have on the economy. Absolutely.

And then also just this idea that there's like, get a visual. different growth or inflationary impacts of different kind of fiscal policies. So, right, if like, you know, if you were to give Bill Gates a, you know, one billion dollar tax cut or some, you know, whatever it is, it's probably not going to do much because Bill Gates has more money than he knows what to do with. Whereas if you were to put it towards consumption and particularly consuming something that we don't have much capacity in like housing or something like that, then you might see a real growth or inflationary impact. or bicycles. I like your free bicycle idea. Let's do that one. Yeah, I support that. One other

point I think is key. And if you just sort of think to really sort of drive at home in the last year, there has been all this question as like, all right, the tax cuts are blowing out the deficit. And people are like, oh, who's going to buy all that debt? And the simple answer is like, well, a bunch of people just got tax cuts. And so they're going to have a lot more money. So we can sort of already know who's going to buy it. It's those people that have more money in their bank account. Like, it's sort of if you think of this closed loop phenomenon, it allows you to sort of anticipate who is the new entity that's going to be doing the buy. The closed loop strikes again. I like it. Yes. All right. Well, this has been another edition of the Oddlots podcast. I'm Tracy Allaway.

You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisethall. You can follow me on Twitter at the stalwart. And you should follow our guest, Brian. Roman Chuck on Twitter at Brian Romanchuk. And be sure to follow our producer, Tofer Forges at Forges T, as well as the Bloomberg head of podcast, Francesca, Levy, at Francesca today. Thanks for listening. The news doesn't stop on the weekends. Context changes constantly.

And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini. We'll bring you the latest headlines. in-depth analysis and big interviews. All the stories that hit home on your days off. And I'm Lisa Mateo.

Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays, we speak with journalists, columnists, and key political figures

to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts.