One factor pushing interest rates higher? Growing domestic ownership of U.S. debt

Back in the early 2000s, foreign investors owned the majority of the debt issued by the U.S. government: almost 60% of it in 2008.

But since then, the market for U.S. debt has shifted toward domestic investors. Now, foreign investors own just a quarter of all U.S. debt.

That shift in ownership can have consequences for interest rates throughout the economy.

When foreign ownership of U.S. debt was booming in the early 2000s, a lot of emerging markets — especially China — were making lots of stuff, selling it to the U.S., and pulling in dollars.

“And often those were then recycled back into Treasurys,” said Alex Wolf, global head of macro and fixed income strategy with J.P. Morgan.

Wolf said the investors doing that recycling were largely foreign central banks. They liked holding big reserves of dollars in the form of Treasurys, in case they needed them to support their own economies.

“They weren’t thinking about what is the right level of yield, they weren’t trying to time the market when they saw yields spike and go in when bonds were cheaper,” Wolf said. “They were simply less price-sensitive, so you had more of a persistent source of demand.”

Over the last couple of decades, though, that demand has been tapering off. Countries haven’t needed to hoard dollars, because their economies are more resilient. And Wolf said after the financial crisis in 2008, global trade slowed down, which meant foreign countries weren’t pulling in as many dollars.

“That has also slowed down, and reduced the demand and need for purchase of Treasurys,” he said.

But it’s not like the world stopped buying U.S. bonds altogether. As foreign demand for Treasurys started to slow, other domestic investors came in to fill the void.

Anusha Chari, an economics professor at the University of North Carolina, said those domestic investors include institutional investors, pension funds, and other investment funds.

Chari said many of these investors don’t behave like foreign central banks, which tend to buy Treasuries and hold on to them.

“They are more sensitive to market sentiment, and whether we are in risk-on or risk-off states of the world,” she said.

For instance, a big chunk of today’s Treasury buyers are hedge funds, which often buy Treasurys with a lot of borrowed money. As a result, those investors tend to be more skittish, said Gian Maria Milesi-Ferretti, a senior fellow at the Brookings Institution.

“So if market conditions sour, those investors are going to sell very, very quickly,” he said.

Milesi-Ferretti said this isn’t an abstract concern. This actually happened right when the pandemic started.

“There was a moment of panic, a dash for cash, when there were massive sales of longer-term Treasury securities,” he said.

That massive sell-off pushed down the value of Treasurys, which means it also pushed up yields. Milesi-Ferretti said that’s why the shift toward domestic ownership of U.S. debt makes it more likely that interest rates will rise whenever markets are stressed.

“That is a reason why there are more worries now about the Treasury market than during previous periods of turmoil,” he said.

And higher rates during a period of turmoil can make things even worse.