Addicted to Debt: Foreign Purchases of U.S. Treasuries and the Term-Premium

Abstract

This paper investigates the effect of purchases of U.S. Treasury bonds by foreigners on long-term yields and the term-premium. I set up a consumption-based model with habit preferences, calibrate it to match the average slope of the yield curve in the U.S., and find that foreign purchases decreased long-term yields significantly over the period prior to the financial crisis. Half of this change is explained by a drop in the term-premium: in the model, foreign purchases increase domestic agents' consumption above their habit, thus reducing their risk-aversion and decreasing the term-premium. Finally, I investigate the potential impact of a sell-off of U.S. Treasuries by foreigners. I show that such a reversal of foreign inflows would result in a sharp increase in the term-premium and, thus, in long-term yields.

Keywords: term-premium, long-term yields, U.S. Treasury bonds, habits

JEL Classification: E43, E44, G12, G15