As Washington's spending continues to outpace tax revenues, so will its debt issuance. Since spending does not appear to be decreasing anytime soon, and tax revenues will have a difficult time increasing during a recession, the national debt will continue to expand. Many have argued that at some point, the buyers of that debt will become uncomfortable with the U.S.'s debt levels. When that happens, they will demand greater yields. But when will that day come? It may have already.
While Treasury yields don't seem to have increased drastically since the beginning of the year, that borrowing cost increase might be manifesting itself through a different means: the issuance of more Treasury Inflation-Protected Securities, also known as TIPS. According to an article in the Wall Street Journal, TIPS issuance is increasing. That's likely because borrowers are worried that the U.S. may try to inflate away its debt. TIPS would protect investors from inflation ruining their return, because TIPS yields adjust with inflation at a rate pegged to the consumer-price index.
Which borrowers are worried? One of the prominent names might not surprise you: China. The WSJ says:
China, the largest holder of U.S. government debt, is among investors that have indicated to the Treasury that they want to buy more of the securities, which offer protection against rising inflation, the people said.
Officials from the U.S. and China discussed TIPS issuance at high-level talks in Washington last week. U.S. officials assured their Chinese counterparts that they remained committed to TIPS sales, according to a person with knowledge of the discussions. China has accumulated more than $2 trillion in foreign-exchange reserves and has invested about $800 billion in Treasurys.
More TIPS issuance would likely boost demand for Treasury securities. Last week, demand for Treasurys was quite weak. But do TIPS really present a higher borrowing cost? That depends on inflation. If the naysayers are right, then TIPS will, indeed, be more costly than regular Treasurys. The higher the inflation, the higher the cost.
On the flip side, however, if the critics are completely wrong, and deflation grabs hold of the economy, then TIPS would actually turn out to be cheaper than regular Treasurys. I find that unlikely and worry that the issuance of more TIPS plus inflation could cause U.S. debt to increase even more.