Will China Selling put Upward Pressure on US Treasury Yields?

There's been more than a little attention devoted to this question lately. The concern follows reports that China has been selling portions of its massive US Treasury holdings to support a destabilized Yuan. 

Marketwatch had a nice piece this morning that should dispel much of investors' concerns. This chart from Marketwatch shows net flows of foreign private and official sector purchases of Treasuries. Despite recent selling pressure, private sector purchases appear to be more than offsetting the selling of foreign governments.

Here are some other factors to consider that should equally support US Treasury prices, if not exert downward pressure on bond yields. First, as reported elsewhere, China cannot dump its holdings of UST for fear of price instability and also the question of where to go to reinvest some $1.2 trillion of proceeds. Second, if the world is really trending towards deflation, as is being reported, US Treasury bonds will climb in value. As inflation erodes the value of fixed income securities, deflation produces just the opposite effect. Third, lower US budget deficits (for however long that lasts) will decrease UST new issuance. Fourth, US pension funds are increasingly talking about "de-risking" their investment portfolios, by selling equities and corporate bonds to move into US Treasuries and other safer investments. 

Given these considerations, don't be surprised if near-term the 10-year heads back towards its January 2015 low of 1.68%, particularly if there's a flight to safety trade following a stock decline.

The Public Pension Crisis: Illinois, New Jersey and Puerto Rico

The US protectorate of Puerto Rico has captured headlines for several weeks now following its default on US dollar tax-exempt bonds. The default occurred on August 1, when the Commonwealth paid only $628,000 of a required $58 million payment due bondholders of its Public Facilities Corporation. The consequences of default for the island are severe, as seen most recently when a proposed new $750 million bond issue to fund needed improvements to its water system failed to attract buyers, causing underwriters to pull the sale.

For some time prior to the bond default, concerns with Puerto Rico's credit began to surface with high levels of debt and mounting unfunded liabilities of its employee pensions systems. These unfunded pension liabilities served to magnify the Commonwealth's already hefty public indebtedness. Puerto Rico is now faced with $72 billion of unpaid bonds, plus $33 billion of unfunded pension liability, or $105 billion in total obligations.  For an island with only 3.5 million people, that's $30,000 per capita.

What bond investors are now beginning to realize is that pension liabilities are tantamount to debt. They must be weighed equally in evaluating the level of government debt burden and its capacity to repay its obligations. This concern was highlighted by the outcomes of recent U.S. municipal bankruptcy cases, where public bondholders were paid as little as 12 cents on the dollar, only to see retirement obligations of the local government paid in full. This turn of events has the effect of investors not only recognizing that pension obligations are debt, but debt that may also be a superior obligation, to be paid first in a time of financial crisis.

This has us thinking about some more highly rated municipal credits, like New Jersey and the State of Illinois, and what their true debt burdens might be, considering unfunded pension liabilities. New Jersey, fortunately, fairs a little better than Puerto Rico, with $84 billion of State public debt and $87.6 billion of unfunded pension liabilities, or $171 billion in combined debt overall. Spread over 8.9 million residents, New Jersey total debt per capita is on the order of $19,000.

For Illinois, with $127 billion of bonds outstanding, debt burden is considered "moderate" by the bond rating agencies. But adding $167 billion of unfunded pension liabilities, brings their total amount due to creditors to a whopping $294 billion.  Measured on a per capita basis, this ranks Illinois with 12.8 million people and total debt per capita of $23,000 just behind Puerto Rico. Unlike Puerto Rico, however, residents of many cities (and counties) in Illinois have the added debt and pension burdens of their local governments to contend with, as well. In the case of the City of Chicago, this would add debt per resident of $23,000 to the Illinois state total, or a total debt per capita of $46,000, far greater than that of Puerto Rico.

Means Testing Social Security

Chris Christie's recent comments about means testing Social Security benefits set off a torrid of accusations of Republican cuts to Social Security. Leaving aside the obvious fact that Governor Christie is only one of more than a dozen candidates running for the Republican nomination, critics nonetheless seized the opportunity to indict the entire party for mistreating senior citizens. Social Security reform has been called the third-rail of American politics, and Christie received quite a jolt.

But what is means testing about and can it help restore the solvency of the Social Security Trust? As discussed in previous blog posts, the 2015 report of the Trustees of the Social Security Administration clearly spells out the trouble ahead for Social Security. By their estimates, Social Security will be insolvent by 2034, with the Disability Insurance component becoming insolvent next year. The Trustees point to the present value deficit of the Trust Fund, now running $10.7 trillion. Argue all you will about what to do, but clearly something must be done, unless our intent is to bury our heads in the sand and simply leave the mess to future generations.

With a deficit that large, there are only two possible avenues to cure the problem: increase payroll taxes to boost the income side of the equation, or reduce outflows. Those leaning left advocate the former, those leaning right, the latter. We've pointed out in other blog posts, though, the limitations and consideration with raising the payroll tax rate. So let's spend a few moments examining other options.

Means testing, as discussed by Governor Christie is an attempt to gradually reduce outflows of Social Security by reducing benefits for those who need them least: the wealthy. The idea is test the means of financial support of retirees, before providing scarce resources from an impoverished and soon insolvent Social Security Trust Fund. Left leaning opponents of this plan are quick to characterize means testing as a Republican attempt to cut benefits, when in reality, it is simply attempt to limit benefits to the wealthy. 

Paul Krugman blogged about this earlier this week from his platform as acting-editor of the New York Times in a sensational piece entitled, "Republicans Against Retirement". Catchy, no?  In bolstering his argument that means testing is impractical, he and other Democrats with political aspirations, point to just one study on the topic, a sloppy bit of economic research by Dean Baker of the Center for Economic and Policy Research. That study based upon 2009 data, concluded that means testing would save very little, as "more than 75% of Social Security benefits go to individuals with non-Social Security incomes of less than $50,000 per year". Sounds reasonable.

But let's stop and think about this. First, this is 2009 data, that comes at the depth of the greatest recession since the Great Depression. Second, Baker is not referring to those individuals with pre-retirement annual incomes of less than $50,000, but rather those in retirement claiming income for tax purposes of less than $50,000. So he is measuring retirement income from a combination of pension income, private investment income and capital gains, and taxable distributions from 401(k) and IRA accounts.

As you might imagine, retirees, like everyone else in America, are doing their best to manage their tax liability. Thus, retirees are only reporting investment income to the extent they must, often choosing tax-exempt investments like municipal bonds, and avoiding capital gains on stock investments. Thus, someone who has $10 million invested in tax-exempt bonds, and earned $500,000 in annual investment income, would record non-Social Security income of $0.00 (assuming they had no pension or other income). Similarly someone with an IRA of this same amount may choose to take distributions of $50,000, as a prudent way of managing income and tax liability.

But let's leave these obvious considerations aside (as does Mr. Baker in his analysis). Let's also ignore the fact that we're working with income data that is six years old. The point is, Baker's study still reports that 3.4% of Social Security benefits are provided to retirees with greater than $80,000 per year in non-Social Security income. With total benefit outflows of Social Security last year of just over $706 billion, were these benefits means tested and reduced, the annual savings to Social Security would thus be in the range of $24 billion per year. It may not fix the entire problem, but that ain't chump change to a system with a $10.7 trillion deficit.