This Is What's Actually Happening When The Government Auctions Bonds

lots of talk about bond vigilantees staging a comeback. We've seen lots of forecasts from various analysts about just how big the US deficit is going to get. Given Trump's propensity to borrow and also enact fiscal stimulus. There is a lot to discuss when it comes to the world

of US government debt nowadays. There absolutely is, And I think one of the things that's always driven me crazy, I think both of us crazy, is the sort of naive view about how people talk about government debt, particularly US government debt. There's this view often that sort of sees the government as just sort of a typical borrower, like a household or a person trying to borrow money

to buy a car. And as we know, it doesn't really work that way, and that can really lead people to a lot of false assumptions, like about what interest rates are going to do and what the market is going to do. So, I know you say it's a naive viewpoint, but I'm going to make a confession here and say that you know, in my head, I understand the point that the US government is not the same as you know, the head of a household who's tatting

up their income versus their expenditure every month. But deep down in my gut, I have always been uncomfortable with the no shin that the US can borrow extraordinary amounts of money and not have major major impacts. So I'm actually really excited to dig into this subject because hopefully it'll make me feel better. Yeah, I agree, there's a

non intuitiveness about it. And even if you say, like, oh, you know, the US creates its own money and borrowing for the government is not the same as it is with the household, I know what you're saying about your like, well, yeah, surely we must be still getting close to some risk. So hopefully we can maybe usual this episode to get a little more comfortable with thinking about what government did

means in a slightly different manner. Yeah, that sounds great. Great, So today I'm very excited to welcome to the podcast Brian Roman Chuck. He is the author of the Bond Economics blog. He's a financial consultant. He's written about the bond market and what really happens. He's a veteran of the financial industry, and he is going to help us understand what's really happening when the government issues all this debt, which of course is a major theme of the news

these days. Ryan Romantric, thank you for joining us on odd lots. Let's start with the big question when someone or a bank or an investor is buying a government bond, what does it actually happen? On paper, it does look similar to buying another bond. You know, you transfer money to someone in exchange for a security which has a que sip, so there is some similarity. You're you're going through the same Selman process, and you know, you you

end up with rights. If you buy a ten million you know, once you have control of it, then you get you know, a certain contractual payments, you know up until the bond maturity. And any bond, uh, well standard bonds all have the same source of structure will give you a certain coupon and then there's a final principal payment. So the cash flow perspective, all bonds are similar in

that sense. So, at the risk of using a terrible cliche, you know you're getting this IOU from the government essentially, um it comes with a coupon, which kind of informs the yields that you're going to get. Most people when they think of US government debt, they're going to think of treasuries obviously, and they're going to think of the U. S. Treasury. Is it the US Treasury who is actually selling these things? Or are there other entities involved? The U? S. Treasury?

The auction it as a Canadian I forgot the exact details, but it's done there. There's an auction and the the auction is they say there's gonna be a certain number of bonds and then at a certain maturity, and then the line of bidders and most of the bidding comes from there. They're called the primary dealers, mainly banks, but they're security dealers deal with the FED and they're obligated to bid and they do most of the bidding. Other entities.

You can do a non competitive bid, but that's usually a small part of the market. And once all the bids come in, you don't give a price. You just say I want to buy it at this yield. And then you once all the bids come in, you say the you know, it's a lower yield is essentially higher price.

The lowest yields to buy all the bonds win the auction and they get the bonds delivered to them, and then usually the primary dealers sell them on to other, you know, investors like pension funds, people like us and in the secondary market. Now, one of the things that we talked about this in the intro is that we have to dispel the myth that the US is just like any other private sector borrower. And so we've established

that the bonds on paper look the same. It looks like any other corporate bond or alone that might get turned into a bond like instrument, but it's fundamentally different and the key difference is the source of fund So explain to us structurally why the US is a different kind of borrower. Well, the key difference, and you know, for the US, the US controls the central bank, and as the horrible counterexample is a place like the Euro Area,

where the countries don't control their central bank. And because ultimately all these bonds say we're paying you U S dollars and the US dollars a liability of the US Federal Reserve, and the US Federal Reserve the FED is owned by the Treasury. So that gives you the one big picture difference than any other borrower, and the other the other issue is for the government, there main concern.

They're more concerned a bit about the macro consequences of spending and not so much the financial A smaller borrowing an individual bank, you know, how big they might be, aren't really worried about the fact that they're spending on the overall economy. And that is a key difference in understanding, Well, you know, why are they different? Okay, so I'm gonna let my gut talk now, which is probably a mistake,

but here we go. So, why why can't the US government just borrow as much as it wants, you know, enormous amounts of money? Uh what what? What are the negative effects that are going to happen if it does that? It's not the borrowing per se, that's the problem because the it's you would say, if there's a problem, it would be on the spending, because you say, what is the government buying? I mean, maybe they're buying good things, maybe it's bad things, but uh, one can always debate,

you know, what the the spend money on. But from a macro perspective, what the worry is if the government starts buying too much stuff, they drive up the price of everything, i e. There's inflation, and they spend a lot and causes inflation. But the borrowing is the flip side of the spending because if they're spending more than coming in from taxes, there's a fiscal deficit, and the way that that's matched in practice is well that that's

covered by borrowing. And so the borrowing comes with the spending. And so it's a mistake to worry about the borrowing

and say what what is the government spending on. So this is the part that I think people really have a hard time, is why we shouldn't worry about the borrowing because in theory you would think, Okay, people are buying government dead, and the government dead just keeps going higher and higher, and that maybe one day these buyers will say whoa, You guys are spending so much money, You're never gonna be able to pay it back. Tax revenues aren't coming anywhere close. I'm not going to buy

government debt anymore. So this issue, I think is still what we need to address, which is why is that not a risk that one day lenders just won't show up? Well, I mean that that is a worry, and it was anyone's being around the markets that was a worry. I started in finance about Japan and even that was a big worry. And that continued and it was called the widow maker trade people and all Japan is gonna default within months, and they short a Japanese government bonds and

they kept losing money. By now people have largely given up on that. But the reason why the governments can get away with this, uh generally is they're spending creates the money that then is sucked back in by the bond auction. It's a circular flow. And this is why, yes, there's a demand for like you know, the demand for borrowing for the government at the same time they're supplying money that then is recirculated back into the bond market.

I think this is the just sort of the really key point here, and I want to sort of really dive into this. So let's say the government wants to spend ten billion dollars more on some new aircraft program for the military. That ten billion dollars that they spend, I think, as you're saying, winds up in the bank account of some private defense contractor, and then that money in the bank ends up going perhaps a security circuitous route, ends up back being invested in government bonds. Do I

have that right? Yeah, that's basically it. I mean, now it's it's a bit more common because you have excess reserves. But what happens is if the government sends a defense contractor ten billion, they'll have a ten billion deposit on the bank. The bank in return, they get ten billion transferred to them from the FED and they have ten

billion as a deposit the Fed. I mean, these are reserves, and you know, because the Federals is a bank and so but the bank doesn't really want I mean, independent of what them, the customer and what might want, that ten billion UH is sitting in the bank account because

they will have expenses. But the bank itself, what's it going to do with the ten billion it has an asset on balance sheet which is a deposit of the FED, which is a low risk asset which pays you used to pay nothing but now very little, and say we want to do something else with this asset in our balance sheet, And so they then go out and say we want something and gives a higher return, and essentially how the loop gets closed and say, look, hey, there's

you know, treasury bonds. We buy them. They should have an expected return higher than lee ving the money on deposit the FIT. And so the bank will go out and buy the treasury bonds in the auction because otherwise they're stuck with the deposit the FED that's paying them very little. So Brian just on the money creation point when it comes to the US is government borrowing. A lot of people will often point to the special privilege that America enjoys by virtue of the fact that the

US dollar is the world's reserve currency. In other words, other countries need it, and so they're going to keep buying US treasuries in order to stabilize their own accounts and their own currencies and things like that. How much does that play into the ability of the US government to keep borrowing. And you know, you mentioned the Japan example. People have been worried about Japanese government debt for ages.

The end certainly is not the world's reserve currency. So how come they're able to do that as well as the US the reserve currency when you had to fix fixed exchange rate regime. It did make a difference in Bretton woods, but it's been a long time. Canada, Australia, United Kingdom, I mean, they're not really reserve currencies, but they're pretty much in the same position as the US from the perspective economic perspective. Let's say you have an

Asian central bank. They look as far as the U S. Domestic economy is concerned, they're a private sector borow and they have the same choices to do, you know as any other private sector investor. What do we do with our with our U S. Dollar assets? And you know, they could hold cash, they could they could leave money on deposit the bank, or we could buy a treasury. So they don't really have a choice if if they want to hold US dollar reserves, they have to do

something with it. And by convention, you know, they don't run around. It's it's it's frowned upon for central banks to run and run around and buy private sector ass it's like equity easy. There's a little bit of dabbling in equity markets, but that's only a tiny fraction. They keep their money in fixing comme assets, and they want safe ones. I mean they don't because they might need to call on their reserves if their currency is under attack.

And then you know, they don't want a private debt that's in the process of defaulting when they need liquidity, and so by default they tend to end the treasury. So it's a two way street, and a certain extent they're trapped into the treasury holdings as well. And in theory, if a foreign holder of dollars, let's say they did want to buy equities instead of treasuries just for whatever reason, that would create some new holder of those dollars at some other bank. And so it's not like the dollars

would just sort of disappear. It would be yet another buyer somewhere else would show up who would have dollars on reserve at a AC and then would theoretically go into treasuries. Yeah, it's it's for everybodyer. There's a seller and scare stories often revolve around forgetting that that basic principle. Yeah, there's someone with the dollars has to buy, so yeah, you know, the pricing can change, of course, I mean

that's the thing if you're worried about pricing. Yes, treasury prices would go down relative to other things, but the flows will still cancel out. So how come Japan can borrow enormous amounts of money, Well, it's the same same issue. There's excess again. They're creating again and um I even looked at the latest data, but they're roughly a trade balance, so it's mainly domestic owners. Very few people want to go in and buy Japanese bonds. I mean people buy

Japanese equities, but not bonds. People just think they're ridiculous, although now maybe not so as much. But the you know, the yen has is somewhere in the system and Happanese banks basically have no choice, but they buy the bonds, although recently it's been the Bank of Japan. They've basically bought most of them up and now the banks just

have deposits of the Bank of Japan. But in the in the end, it's just that if they spend the end end up in the system, and the end has to go somewhere, and that drain is the Japanese government bond market. So doesn't matter if the buyers of your debt are more domestic or more foreign. Is one group better than the other. If you're borrowing in your own currency, I mean, this is very different. If you're like an emerging market borrowing in another country's currency, then you have

to be very worried about foreign holders. Or if you have any fixed exchange rate pig and you see that in the Euro area, then you like domestic things, domestic buyers of your debt because you have more control over things. But for a floating currency sovereign if you have a lot of fire and foreign buyers, if you do, it means you're running big current account deficits. And is that good? Is that bad? You know, the US, their industrial strategy since being the World War two, has been running trade

deficits with you know, strategic partners. And you know the U s has costs, and there's benefits for the US right now that people are focusing on the cost, but there's there are benefits the way the US runs a system. But the foreign buyers. In theory they could panic more, but at the same time they don't want to lose money. You know, it's very you know, if you're a big holder of bonds, you can sell in a panic and

you can lose a lot of money. You know. I worked for firm which was large, and if we wanted to, we could lose a lot of money very quickly by selling our our assets and a panic. Well, that's not our job. Your job is not to lose money very quickly, so you generally avoid doing stuff like that. So that's why, on paper, the foreign investors could get spooked more, but they still want to make money, so it's not clear

that they're much different than domestic investors in that respect. Okay, so we've established that for the US credit risk isn't really a thing because the dollars that come to buy treasuries come from the spending. And we've also established that you don't even need to be a reserve currency for this phenomenon to exist, because it's in Japan, which has lots of debt, and Canada, which is not anyone a reserve currency, Australia and New Zealand. Then the obvious question

is why can't all countries do this? And so people think, to the extreme example of a country like Venezuela and the debt they have, why can't they just spend and keep a stable currency and a stable market. I'm not an emerging market person, but there's policy differences between Venezuela and the US coming down to the strength of the

tax system. The i r S, as everyone knows, is a powerful organization, and it has the income tax, has the ability of damping economic activity, and so it controls inflation better than in the country with a weaker tax system. And my pet theory is that the difference comes down to the effectiveness of the tax regime for for inflation control. I mean, that's a major difference, but there is also a question of what is produced. If you if you're dependent on foreign imports for a lot of goods, then

your domestic inflation is driven by your exchange rate. Whereas the US is largely a closed economy I mean, relatively a closed economy when compared to other countries, and change is the exchange rate don't have much of an effect on prices, so you can largely ignore I mean, if US dollar falls ten, it's not really noticeable in domestic prices.

So with all the talk of the US deficit growing and the US government borrowing more under the current administration, lots of auctions happening, not just a longer term treasuries, but also t bills. What are you looking out for when it comes to US auctions to sort of gauge the health of the market and to determine how successful an auction is in terms of successive auctions. That was something that that was a technical detail I didn't worry about. But the the overall trend it's going to be. Are

these deficits going to cause rapid growth? If you're if you're worried about the pricing which is the usual word, what's gonna happen to bond yield? If the government spending a lot, they'll will have inflation your pressure, and that's going to force the Fed to hike rates and that if you know from a bond market, uh, you know, pricing perspective, that's your worries that the Fed gets more aggressive with rate hikes and pushes up bond yield. That's going to be you know, much much more of a

concern than the just supply demand. So the big picture, and if we sort of wrap it all up here is that it's not the borrowing per se. It's not the gap between the government's expenditures and its revenues via taxes. It's really about the capacity of the economy to absorb all that spending. That sort of is what theoretically would drive inflation, and then the link between inflation and what the Fed does that would sort of be what ultimately

determines what long term rates are going to do. And then that you know, once you answer that, then you can decide whether it makes sense to buy a bond or not. Yeah, that's basically I mean, And the question is will I mean, it's not just a simple difference. I mean, this is the question. With the tax cuts, how much for stimulative impact have they had. I mean,

there's been not much of an inflationary impact. It's been good for the stock markets, a lot of money got funneled into into stock buy backs, but by itself, that isn't that isn't putting inflationary pressure on the economy. So there's a big difference between what the deficit is doing and the effect on the economy. And it's hard to model. I mean, it's it's it's not an easy thing to

say what the effect on the economy is gonna. Presumably there's a big inflationary difference between say, rich people are getting a tax cut versus a policy that said, everybody in the country gets a new bicycle, even if it's on a dollar amount, it costs the same. That's presumably the difference. I mean, you might have political this is where sort of politics comes in. People might disagree, but that's certainly my view that you you know, hand the tax cut to the bottom twent or you buy stuff

much more inflationary than capital gains tax cut. Brian Roman Chuck, thank you very much. Very interesting conversation, and I think these sort of this guts of how this all works out very rarely discussed when people talk about the bond market. So appreciate you coming up. Thanks thanks to It's nice to be on so Tracy. Are you convinced that it's not a big existential threat for the government to run

what's on paper very large deficits. I feel like I have a better intellectual grasp of what's going on, and the idea that you know, borrowing from the government isn't actually about moving money from one entity to the other. It's actually about creating money. I get that, but I gotta be honest, Joe, part of me is still thinking there have to be some consequences. I think there's two

things that I think we're really useful there. So one is obviously just really understanding this idea of the closed loop, this idea that money never leaves the banking system, because I mean, for one thing, we know that all money is digital basically, and so kidd just disappear, and so if it's going to stay in a bank, and a bank will ultimately put it into treasuries, even if it

caused many hop skips in a jump. I also think that point that he made about the strength of institutions is really important, and this idea that it's not necessarily the borrowing per se that you want to worry about, but if you want to look at sort of institutional degradation in developed economies, you could certainly point to a

lot of things these days. Right, And we've had this discussion at one time or another about how when you're ramping up government borrowing, you're really making big decision and about what you're going to spend that borrowing on, and those are value decisions that are being made. The other thing I thought was interesting was when he sort of flipped it on his head and said, you don't necessarily need to worry about the borrowing, but about the capacity

of the economy to absorb the spending. And that's something that you know, you've seen the Federal Reserve make noises about it, this notion that we are running close to full capacity at this point. And what impact is a whole bunch of fiscal stimulus actually going to have on the economy. Absolutely, and then also just this idea that there's gonna be different growth or inflationary impacts of different

kind of fiscal policies. So right, it's like, you know, if you were to give Bill Gates a you know, one billion dollar tax cut or someone, you know, whatever it is, it's probably not gonna too much because Bill Gates has more money than he knows what to do with. Whereas if you were to put it towards consumption, and particularly consuming something that we don't have much capacity and like housing or something like that, then you might see a real growth or inflationary impact. Or bicycles. I like

your free bicycle idea, let's do that one. Yeah, I support that. One. Other point I think is key and that and if you just sort of think to really sort of drive at home. In the last year, there has been all this questions like all right, we're the tax cuts are blowing out the deficit, and people are like, oh,

who's gonna buy all that debt? And the simple answer is like, well, a bunch of people just got tax cuts and so they're gonna have a lot more money, so we can sort of already know who's gonna buy it. It's those people that have more money in their bank account. Like it's sort of if you think of this closed loop phenomenon, it allows you to sort of anticipate who is the new entity that's going to be doing good buying.

The closed loop strikes again. I like it. All right, Well, this has been another edition of the Odd Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway, and I'm Joe Wise of Thall. You could follow me on Twitter at the Stalwart, and you should follow our guest Brian roman Chuck on Twitter at Brian roman Chuck, and be sure to follow our producer to fur Foreheads at Foreheast as well as the Bloomberg head

of podcast, Francesca Levy at Francesca Today. Thanks for listening.