The obvious conclusion is that it will push up the yields on Treasury securities – bills, bonds and notes – that are already elevated because of the Fed’s 11 rate rises since March last year. The federal funds rate is at its highest level since 2001.

The US bond market is the world’s biggest and most liquid, and it will absorb the deluge of bonds in prospect – but there will be a price paid for that scale of supply. Bond prices will fall and yields will rise (there is an inverse relationship between the two) relative to where they might otherwise have been.

The obvious follow-on question is: who will be the buyers?

The most significant buyer of US government debt for much of this century has been the Fed, via several of its “quantitative easing” programs, or purchases of government securities and securitised mortgages. The most recent burst of quantitative easing was during the pandemic, with the Fed’s balance sheet more than doubling from about $US4 trillion to almost $US9 trillion in less than two years.

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However, the Fed was engaged in quantitative tightening from June last year, in tandem with its rate rises. Its balance sheet was shrunk by allowing securities it holds to mature – without reinvesting the proceeds – at a rate of up to $US95 billion a month. Up to $US60 billion a month of that $US95 billion was Treasury securities.

Since May last year, the Fed’s balance sheet has shrunk from $US8.91 trillion to about $US8.24 trillion, with the run-off of the Fed’s holdings continuing and withdrawing liquidity even as the US Treasury is pumping it back in via its increased deficits and its debt issuance.

If the Fed is on the sidelines, other buyers will need to step up.

Japan and China are the two biggest sovereign holders of US government debt.

China has been steadily reducing its bond holdings in the past few years – from a peak above $US1 trillion to around $US860 billion – even though it has broadly maintained its exposure to US dollar-denominated assets.

Japan has around $US1 trillion of bond holdings, but Japanese-related investment in Treasuries is more likely to fall than rise.

There have been signs that Japanese investors – and hedge funds employing carry trade strategies using cheap Japanese debt to invest in higher-yielding US debt – are starting to repatriate some of those funds.

With the very recent shift in the Bank of Japan’s monetary policy to allow yields on its bonds to rise slightly, the relative appeal of Japanese government debt has improved and the returns from the carry trades have been squeezed.

When the regional banking crisis developed in the US earlier this year, there was a big shift of deposits out of those banks into the big banks and money market funds. A lot of the funds’ cash is held in overnight repurchase agreements with the Fed.

That cash is seen as a likely source of buying for the flood of government securities from now until the end of the year. The higher yields may also attract bank deposits more directly and investors in other assets may cash them out to lock in the attractive, essentially risk-free returns from the bonds.

If the Fed is on the sidelines, other buyers will need to step up.

That could be a threat to the sharemarket, which has been on a big run since last October, and especially to some big tech companies trading on multiples of their future earnings that are difficult to rationalise in a rising interest rate environment. (The 10-year bond yield is the key input into calculations of the net present value of their future cash flows – as it rises, that net present value falls).

Despite Fitch’s move and the highly-charged, dysfunctional political environment in the US that it cited as a reason for its downgrade, higher yields will also attract a range of foreign investors to what is still regarded as the safest and most liquid market in the world.

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There might be some institutions whose mandates don’t allow them to invest in anything less than AAA-rated securities, but that should have a limited effect on demand if the price is right.

The market will absorb the deluge of US government debt but there is potential, in a fragile global environment, for it to have flow-on effects for other markets, other corners of the financial system and for the US and other economies, particularly as the likelihood of continuing increases in the US deficit over the rest of the decade and beyond means that increased call on global savings won’t be a temporary phenomenon.

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