Real World Economics: Bonds Part 2: How this affects us

Edward Lotterman Economic news for our nation this past week has not been good In his erstwhile self-appointed role as the fourth branch of regime Elon Musk condemned the budget bill eventually passed by the House but stalled in the Senate Such criticism by a billionaire egomaniac capable of funding primary challengers to anyone defying his order may not intimidate every senator But apparently it can scare enough of them to stall the bill the legitimate flaws in the measure notwithstanding Thus a spending bill that would pile on trillions more in U S debt and should have been passed and signed last August for the fiscal year that began in October still hangs fire That shovels additional uncertainty onto households businesses and financial markets already awash with confusion At the other end of Pennsylvania Avenue President Donald Trump once again blasted Federal Reserve Board Chair Jerome Powell over interest rates Too Late Powell must now LOWER THE RATE He is unbelievable That gave financial arena palpitations worldwide The common element for these two events is that the daily lives of concerned U S citizens will indeed be affected by bonds and bond markets this year Last week in this space I gave primer on how bonds and bond markets work This week we apply it to the U S business activity At the Capitol regardless of its final details the GOP s Big Beautiful Bill will give us higher budget deficits in the years ahead not lower ones To finance these the U S Treasury will have to issue at least trillion in new debt bills notes or bonds about every six months going forward This will be done in the primary territory in which new bonds are issued At the White House and at the Federal Reserve the question is whether the Fed will lower or raise interest rates But it can only do that by increasing or decreasing the money supply To accomplish that it will have to buy or sell existing bonds it owns in the secondary realm More on that later Bond markets are open to anyone individuals insurance companies pension plans and so on not only in the United States but from anywhere in the world The Minnesota State Retirement System may buy U S bonds previously owned by a Russian oligarch via a bank in Cyprus by the central bank of Denmark a Fidelity mutual fund or a myriad of other entities Since this region is open to all comers decisions about the Fed buying or selling in it are made by its Federal Open Industry Committee consisting of the seven members of its Board of Governors and the presidents of the system s district banks All participate in deliberations but when it comes to a vote only five of the district presidents vote in an annual rotation Minneapolis Fed President Neel Kashkari is not a voting member this year but will be in Except for the volumes involved borrowing money by issuing new bonds is about the same for the U S Treasury as it is for Xcel Vitality the BNSF railroad or Minnesota State Colleges and Universities Inhabitants and private entities have expenditure banks conduct the sale Given its size the Treasury auctions new bills bonds and notes at weekly monthly or quarterly intervals to large primary dealers These sell on to other buyers The auction is structured so that the bidders promising the lowest interest rates get the bonds Thus the issuing of new bonds to fund federal budget deficits is straightforward The Treasury pays out interest due and will redeem the bonds when they mature Between issuance and maturity however Treasury bonds may be bought and sold multiple times in the open field This gets complicated especially as the Federal Reserve may be one of multiple buyers or sellers Interest rates vary over time in response to a large number of variables including threat and transaction costs but supply and demand are fundamental How a multitude of people have money to lend How a multitude of want to borrow The interest rate is the price paid for the temporary use of money by the U S administration or anyone else That price is revealed in the initial issuing of bonds If governments want to borrow a lot of money they will have to pay higher interest rates on bonds in order to find willing buyers And if a multitude of people want to invest safely but sparse bonds are available savers have to accept lower returns This leads to particular poorly understood outcomes when investments can be bought and sold but that pay fixed interest rates over long periods If chosen owners of such bonds want cash the only way they can be made attractive to buyers is by lowering the sale price below the face value of the bond Return to last week s column s contract-for-deed example Suppose someone has a contract with a balance due and paying interest And suppose that someone wants to cash out by selling the contract However other contracts are being offered that pay The only way the seller of the contract can find a buyer is to offer to sell it for less than the due That will give a feasible buyer an effective return on their resources equal to alternatives paying higher nominal interest Now consider what happens if the U S Treasury is borrowing billion per month at interest on -year bonds But suddenly China or Japan begins selling tens of billions in U S Treasurys they had purchased in the past And suppose China or Japan offers these at prices that make the effective return on money invested for secondary-market buyers greater than what the U S Treasury offers on newly issued ones in the primary sector Regardless of what target the Federal Reserve has set for overnight loan rates the U S Treasury will be forced to pay higher interest rates to issue new -year bonds to make up the difference This effectively takes Powell Trump and the FOMC out of the equation Since the realm determines the price it also sets the rate And because the rate-setting FOMC has to buy and sell in the secondary sector these high rates trickle down to U S households and businesses that are seeking everyday loans The cost of everything goes up That is how a foreign country that owns U S Treasury bonds can force up interest rates in the U S financial system even if the Fed changes nothing That is the poleaxe Chinese Premier Xi Jinping has over his shoulder as he negotiates tariffs with Trump effectively You can put tariffs on our aluminum and steel but we can push up the interest rates on U S home mortgages farm operating loans small-business inventory financing and car loans up a half percent Or a whole percent Or two Yes the Federal Reserve could step in and buy the new U S Treasurys with money created out of thin air But that also can cause inflation And aside from the obvious household impact a rising Consumer Price Index would force all lenders to raise interest rates to keep inflation-adjusted returns from falling And yes China might get fewer dollars for its U S Treasurys than it paid in purchasing them And yes all of this maneuvering might nudge the dollar-renminbi exchange rate in a direction adverse to Chinese exporters But that change might hurt less than tariffs In the real world this is a complicated matter with more than two parties involved It is more than just bond prices interest rates and exchange rates The key lesson however is that as an international debtor even with a large area and having the world s reserve currency like the U S is vulnerable to actions by its creditors This is what Musk and the deficit hawks in Congress understand in opposing the Big Beautiful Bill But political and economic interests are seldom in sync especially with a guy like Trump in the White House No we are not Paraguay or Burundi that had to borrow from banks in a foreign currency No lender can suddenly call in our loan or suddenly refuse to renew it But with foreigners owning trillion of U S Treasury bonds as of March of which at least trillion is held by foreign governments or their central banks we don t have nearly as much leeway as countless in and out of the administration may assume Related Articles Real World Economics Bond primer part Understanding the field Real World Economics Pragmatism not globalist ideology drove U S deal protocol Real World Economics Tax bill full of perverse incentives Real World Economics Remember the money supply It s our main obstacle Real World Economics GDP is key but must be kept in context St Paul economist and writer Edward Lotterman can be reached at stpaul edlotterman com