Edward Lotterman
Economic news for our nation this past week has not been good. In his erstwhile self-appointed role as the fourth branch of government, Elon Musk condemned the budget bill finally passed by the House but stalled in the Senate.
Such criticism by a billionaire egomaniac capable of funding primary challengers to anyone defying his order may not intimidate every senator. But apparently it can scare enough of them to stall the bill — the legitimate flaws in the legislation notwithstanding.
Thus a spending bill that would pile on trillions more in U.S. debt and should have been passed and signed last August for the fiscal year that began in October 2024 still hangs fire. That shovels additional uncertainty onto households, businesses and financial markets already awash with confusion.
At the other end of Pennsylvania Avenue, President Donald Trump once again blasted Federal Reserve Board Chair Jerome Powell over interest rates: “’Too Late’ Powell must now LOWER THE RATE. He is unbelievable!!!” That gave financial market palpitations worldwide.
The common element for these two events is that the daily lives of concerned U.S. citizens will, indeed, be affected by bonds and bond markets this year. Last week in this space, I gave primer on how bonds and bond markets work. This week, we apply it to the U.S. economy.
At the Capitol, regardless of its final details, the GOP’s Big Beautiful Bill will give us higher budget deficits in the years ahead, not lower ones. To finance these, the U.S. Treasury will have to issue at least $1 trillion in new debt — bills, notes or bonds — about every six months going forward. This will be done in the “primary market” in which new bonds are issued.
At the White House, and at the Federal Reserve, the question is whether the Fed will lower or raise interest rates. But it can only do that by increasing or decreasing the money supply. To accomplish that, it will have to buy or sell existing bonds it owns in the secondary market. More on that later.
Bond markets are open to anyone, individuals, insurance companies, pension plans and so on, not only in the United States, but from anywhere in the world. The Minnesota State Retirement System may buy U.S. bonds previously owned by a Russian oligarch via a bank in Cyprus, by the central bank of Denmark, a Fidelity mutual fund or a myriad of other entities.
Since this market is open to all comers, decisions about the Fed buying or selling in it are made by its Federal Open Market Committee, consisting of the seven members of its Board of Governors and the presidents of the system’s 12 district banks. All participate in deliberations, but when it comes to a vote, only five of the 12 district presidents vote in an annual rotation. Minneapolis Fed President Neel Kashkari is not a voting member this year but will be in 2026.
Except for the volumes involved, borrowing money by issuing new bonds is about the same for the U.S. Treasury as it is for Xcel Energy, the BNSF railroad or Minnesota State Colleges and Universities. Public and private entities have investment banks conduct the sale. Given its size, the Treasury auctions new bills, bonds and notes at weekly, monthly or quarterly intervals to large “primary dealers.” These sell on to other buyers. The auction is structured so that the bidders promising the lowest interest rates get the bonds.
Thus the issuing of new bonds to fund federal budget deficits is straightforward. The Treasury pays out interest due and will redeem the bonds when they mature.
Between issuance and maturity, however, Treasury bonds may be bought and sold multiple times in the open market. This gets complicated, especially as the Federal Reserve may be one of many buyers or sellers.
Interest rates vary over time in response to many variables, including risk and transaction costs, but supply and demand are fundamental. How many people have money to lend? How many want to borrow? The interest rate is the price paid for the temporary use of money — by the U.S. government or anyone else.
That price is revealed in the initial issuing of bonds. If governments want to borrow a lot of money, they will have to pay higher interest rates on bonds in order to find willing buyers. And if many people want to invest safely, but few bonds are available, savers have to accept lower returns.
This leads to some poorly understood outcomes when investments can be bought and sold, but that pay fixed interest rates over long periods. If some owners of such bonds want cash, the only way they can be made attractive to buyers is by lowering the sale price below the face value of the bond.
Return to last week’s column’s contract-for-deed example. Suppose someone has a contract with a $100,000 balance due and paying 6% interest. And suppose that someone wants to cash out by selling the contract. However, other contracts are being offered that pay 8%. The only way the seller of the 6% contract can find a buyer is to offer to sell it for less than the $100,000 due. That will give a potential buyer an effective return on their investment equal to alternatives paying higher nominal interest.
Now consider what happens if the U.S. Treasury is borrowing $100 billion per month at 5% interest on 10-year bonds. But suddenly, China or Japan begins selling tens of billions in U.S. Treasurys they had purchased in the past. And suppose China or Japan offers these at prices that make the effective return on money invested for secondary-market buyers greater than what the U.S. Treasury offers on newly issued ones in the primary market. Regardless of what target the Federal Reserve has set for overnight loan rates, the U.S. Treasury will be forced to pay higher interest rates to issue new 10-year bonds to make up the difference. This effectively takes Powell, Trump and the FOMC out of the equation. Since the market determines the price, it also sets the rate.
And because the rate-setting FOMC has to buy and sell in the secondary market, these high rates trickle down to U.S. households and businesses that are seeking everyday loans. The cost of everything goes up.
That is how a foreign country that owns U.S. Treasury bonds can force up interest rates in the U.S. economy even if the Fed changes nothing. That is the poleaxe Chinese Premier Xi Jinping has over his shoulder as he negotiates tariffs with Trump: effectively, “You can put 50% tariffs on our aluminum and steel, but we can push up the interest rates on U.S. home mortgages, farm operating loans, small-business inventory financing and car loans up a half percent. Or a whole percent. Or two.”
Yes, the Federal Reserve could step in and buy the new U.S. Treasurys with money created out of thin air. But that also can cause inflation. And aside from the obvious household impact, a rising Consumer Price Index would force all lenders to raise interest rates to keep inflation-adjusted returns from falling.
And yes, China might get fewer dollars for its U.S. Treasurys than it paid in purchasing them. And yes, all of this maneuvering might nudge the dollar-renminbi exchange rate in a direction adverse to Chinese exporters. But that change might hurt less than tariffs.
In the real world, this is a complicated problem with more than two parties involved. It is more than just bond prices, interest rates and exchange rates. The key lesson, however, is that as an international debtor, even with a large market and having the world’s reserve currency, like the U.S., is vulnerable to actions by its creditors. This is what Musk and the deficit hawks in Congress understand in opposing the Big Beautiful Bill. But political and economic interests are seldom in sync, especially with a guy like Trump in the White House.
No, we are not Paraguay or Burundi that had to borrow from banks in a foreign currency. No lender can suddenly “call in our loan” or suddenly refuse to renew it. But with foreigners owning $9.1 trillion of U.S. Treasury bonds as of March 2025, of which at least $3.9 trillion is held by foreign governments or their central banks, we don’t have nearly as much leeway as many, in and out of the administration, may assume.
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St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
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