Behind Bull Market: Fickle Foreign Money

Foreigners have been snapping up US Treasury bonds, bills, and notes like teenage boys downing potato chips.

Central banks and private investors in Europe, Japan, and elsewhere have, in effect, financed nearly the entire federal deficit in the past few years. They pushed interest rates half a percentage point lower than they would have been otherwise, says Dallas economist Michael Cosgrove. That has meant cheaper home mortgages, car loans, and capital for businesses.

Indirectly, foreign buyers of United States government securities propped up the bull market in stocks. When interest rates are low, investors find fixed-interest bonds less attractive than stocks.

But what happens if foreign investors have their fill of Uncle Sam's securities? Interest rates will climb, says Mr. Cosgrove, who writes The Econoclast newsletter, and stock-market prices might tumble 20 percent, an average bear-market dip.

John Youngdahl, an economist at Goldman, Sachs & Co., a New York investment bank, suspects foreign central banks will now ease their purchases of US Treasuries. That's because they have largely achieved their goal of boosting the foreign-exchange value of the dollar, he says. When the dollar is strong, Japanese or German exporters can more easily sell their goods in the US. That stimulates their slack domestic economies.

"[Central bank] demand should not be as great as in the past two years, ... since the economies of most other major industrial countries seem poised to gradually improve and, hence, the rationale for aggressive dollar support efforts is no longer as strong," write Youngdahl and colleague John Simpson.

Private-sector foreign investors, however, should continue putting money into US debt for six to nine months while the gap between low interest rates in Japan and Europe and higher rates in the US remains large, says Youngdahl. But if European economies pick up sharply, their interest rates will rise and tempt investors to keep more money at home rather than in the US.

Purchases of Treasuries by foreigners, recently including China, are huge. In the 11 quarters ending last September, net foreign purchases of notes and bonds (medium and longer-term debt) totaled $361.2 billion, compared with net Treasury sales of $382.2 billion. In the past five years, Youngdahl notes, foreign central banks also have bought about $200 billion of Treasury bills (short-term obligations), more than net sales of $197 billion.

Foreigners in the private sector have expanded their holdings of Treasury bonds and notes by a cumulative 291 percent since 1990 - now owning nearly $400 billion of these assets, several billion more than official institutions. Official institutions, mostly central banks, have raised their ownership 78 percent.

Altogether, by mid-1996, foreigners held $985.6 billion of the $5.2 trillion in gross public debt. This means:

* Interest on 19 percent of federal debt will be paid to foreigners, not to Americans. In a recession, when federal revenues dry up somewhat, that interest bill could be "more burdensome," Youngdahl says. The US doesn't tax foreign-owned Treasury debt.

* Should foreigners decide to sell US government securities in volume, it could have considerable impact on financial markets.

"It need not be a problem for US taxpayers in the future as long as the US government pursues policies that are appropriate and not inflationary," Youngdahl says.

In other words, the globalization of finance is making the US more subject to the discipline of the market, as many other countries, developing and developed, have found in recent years.

In the last seven or eight years, the Federal Reserve has conducted an anti-inflationary monetary policy, and Congress and the White House have edged toward more fiscal restraint. As long as those policies continue, there should be "no sharp shift in the demand for US financial assets," Youngdahl predicts.

Cosgrove, a University of Dallas economist, maintains that the flood of foreign capital into Treasury bonds in 1994 ($79 billion) prolonged the bull market in stocks by preventing the big surge in interest rates that year from being even bigger. Then, he says, the Republican congressional victory in November of that year, with the prospect of reduced federal deficits, encouraged even more foreign investment. As a result, the bull market has lasted an extraordinary 74 months without a 10 percent price correction. Before, the longest such bull market was 45 months.