So when you buy a $100 Chinese product with your debit card, your bank account is electronically deducted by $100 while the Chinese company's bank account is credited by $100. The end result is that, two database entries change in opposite directions at the respective banking data centers. Your account database entry by -$100, the Chinese company's by +$100. That's really it, there are no physical transfers. It is like a score keeping system, where dollars are like points. Same at the other end of the chain. When China buy $10B of treasuries, its reserve account at the Fed (checking account) is deducted by $10B and its treasury account is credited by $10B. That's it, two numbers changed in opposite directions at the US government data centers.
As an analogy, think of what happens when you transfer $1000 from your checking account to purchase a CD. Once again two entries change in opposite directions,. The $1000 is locked up for a period of time in the CD, but it earns interest in return. This is similar to what happens when China buys treasuries. Now here is the question when you transferred money from checking to the CD did the bank get more money?
Now what happens when the treasury bond matures? China's treasury account is deducted by $10B and its reserve account is credited by $10B. All the US government has to do is once again update two entries in opposite directions. Being the issuer of the currency in which the debt is issued, there is no limit to the amount which the government can credit bank accounts in that currency. On the other hand a currency user (which is every one else) needs to have money coming in before it can go out. There is no economic reason by which the US will fail to make a payment. All it does is update numbers in a database. If it does issue a check, then the updates happens when the receiver deposits the check. Really the only way the US government could fail to make a payment is for voluntarily self-imposed political reasons.
The advantages of sovereign currency issuance
There are many reasons why it is advantageous, that our government is a sovereign issuer of currency.. One is that we don't want to end up like Greece, susceptible to the mercy of the bond markets. Greece doesn't have it own currency, so it really does rely on the bond markets for operating funds. It is like a state government in the US. Its 10yr bonds have an yield of 15.24%, its 2 yr bonds are at 33.64%!! (an inverted yield curve). In other words Greece's borrowing costs are ridiculously high. The so called bond vigilantes are pummeling Greece, they view it as a sub prime borrower. Greece probably may have already defaulted if it doesn't keep getting bailed by the ECB (European Central Bank) the issuer of the Euro.
On the other hand, US 10 yr bonds are at 2.56% and 2 yrs bonds are at 0.29%. 10 yr bonds in Japan, with a debt to GDP ratio far higher than Greece, is even lower than the US at 1.01%. Its 2 yr bonds are at 0.14%. There is not going to be much bond vigilantism against a currency issuer, an entity than can create money out of thin air, that is unless the lobotomy party, err.. I mean the tea party gains power and prevents the Fed from acting. There is a saying in the bond markets, "Don't fight the Fed". Investor Cullen Roche has compiled a chart here, which shows there is high correlation between Fed policy and treasury yields. Even the 30 yr bonds show an 87% correlation. In other words, the US is not at the mercy of the bond markets, even given our self-imposed political straight jacket. The Fed may be incompetent at a lot of things, but controlling interest rates is something it does very well.
Additionally we established in Part 1, that even if not at single person buys US bonds, it doesn't matter. As the sole issuer of dollars, does the US really need to get dollar loans to make payment in dollars. Even with current political restrictions the Fed can buy/sell treasury bonds as needed to support policy, it just can't buy it directly from the treasury.
So what is the US bond market really then? It is a really safe place to put your savings. That is how the bond market seems to view it. Take a look this chart from Cullen Roche reprinted below. Even in the middle of last month's debt ceiling debacle the yield was dropping. The yield drops when demand for the bond increases, investors are willing to accept a lower yield for safety. Every time there is economic head winds, investors dump their equity holdings to rush for the safety of treasuries. And when the economic news is better, they tend to leave. Bond investors doesn't seem to concerned at all about US government debt level. Quite opposite what the political class tells us, isn't it. When in doubt follow the money, and this chart below from the Roche article says more than a thousand words. So now can we stop worrying about the debt and focus on jobs.
|Fig 1: CBOE Index that tracks 10yr treasury at 10 times yield (remember lower yield is better)|
Update 8/6: The S&P downgrade may or may not temporarily roil the bond market, no way to know how the hive mind (err.. market) will react, but in the end it should be a non-event. As some observers say, what should be more of a concern is whether there will be a domino effect into municipal bonds or foreign arenas. Downgrading a currency issuer, who's entire debt is in the same currency is meaningless. Japan has been downgraded many times but its yield on 10 yr bonds still remains low at 1.01%.