Investors often seek safety
from financial market turbulence in US government bonds since they offer
virtually no risk of default and, unlike cash or gold, provide a yield. At the same time, sovereign debt default
concerns outside the US, e.g., Iceland, Dubai, and Greece, have
been linked to short-term rallies in the US dollar and have diverted attention
from the fiscal challenges facing the US.
However, since seven US states are in worse financial condition than Greece,
Ireland, Portugal or Spain, shelter may prove hard to
find. With a $3.83 trillion budget, a $12.3 trillion federal government debt, a $1.35 trillion 2010 budget deficit and $63 trillion in unfunded liabilities, the fiscal condition of the US has come into
question and foreign interest in US Treasuries has declined. In late March, it was reported that the 10-year US Treasury Note yield had risen 30 basis
points and that foreign holders of 10-year Notes were selling in record numbers.
Reports of US Treasury
auction distress first appeared in December of 2009 when an article by Eric
Sprott and David
Franklin entitled "Is it All Just a Ponzi Scheme?" questioned the "Other Investors" reported by the US
Federal Reserve. The unidentified
investors held $359.1 billion worth of US Treasuries in the forth
quarter of 2008 but $880.5 billion by the end of the third quarter 2009, an increase of $521.4 billion. Based on the Federal Reserve Flow of Funds Report, Messrs. Sprott and Franklin found the increase
attributable to the "Household Sector", which is defined in the Federal
Reserve's Flow of Funds Guide as "...amounts held or owed by the other sectors ... subtracted from known
totals ... [such that] the remainders are assumed to be the amounts held or owed by
the household sector." Thus, the "Household
Sector" is strictly an artifact of accounting practices, and, as a result,
there has been some speculation regarding the parties responsible for $521.4
billion in 2009 US Treasury purchases.
A recent analysis of 4-week Treasury auction results by
OmniSans Investment Research suggested
that US Treasury auctions are more distressed than has been generally
recognized, and a similar analysis appeared on the popular Zero Hedge
OmniSans and Zero Hedge articles focus on the percent of Treasury auction
purchases made by the Federal Reserve's own primary dealers,
as compared with other bidders, and on the percentage of indirect (foreign)
bids accepted. In particular, the
acceptance of 100% of foreign bids suggests extremely weak foreign demand. While the evidence is accurate, the
conclusion is less clear since the changing pattern of US Treasury auction
results is more complex.
Federal Reserve measures
designed to increase financial market liquidity and to recapitalize the banking
system, such as the Term Asset-Backed
Securities Loan Facility (TALF), represent monetary inflation (or
re-inflation), and some of this currency has certainly found its way into the
coffers of the US Treasury, i.e., a rise in primary dealer purchases. A rise in primary dealer purchases could also
be a result of the low cost of borrowing from the Federal Reserve. In theory, primary dealers can generate
profits simply by borrowing from the Federal Reserve at near zero percent
interest rates and buying Treasuries with higher yields. Of course, primary dealer purchases funded by
borrowing from the Federal Reserve would be tantamount to debt monetization.
An increase in primary dealer
purchases, or in purchases by direct bidders, could compensate for a decline in
foreign purchases of US Treasuries but would not explain it. To be significant, a decline in foreign
purchases would have to be evident in more than one type of Treasury, i.e.,
outside of the reported 1.0 bid to cover ratio for indirect bidders in recent
4-week Treasury Bill auctions.
What may be an emerging pattern
of falling foreign demand and rising primary dealer purchases, both of which have
been moderated by an increase in purchases made by direct bidders (financial
institutions that place bids directly with the US Treasury, such as domestic depository
institutions and mutual funds) is evident in 4-week Treasury Bill auction
Direct Federal Reserve
purchases of US Treasuries (monetization) have been distributed over Treasuries
of different types and maturities and have been generally implemented as a
consistent, low-level of buying for particular Bills, Notes or Bonds. Overall, the Federal Reserve increased its holdings of US Treasuries by $286
billion in 2009, an increase of more
than 60% as of September 2009 compared to 2008, and, as of March 2010, the Federal Reserve's holdings of US
Treasuries had increased another $14 billion to roughly $777 billion.
What is important is that
monetization has been most significant in 4-week Treasury Bills, reaching
38.59% of total 4-week Treasury Bill sales on January 26, 2010, but similar
spikes in Federal Reserve purchases do not appear in auction results for other
types of Treasuries. Thus, it should
come as no surprise that 4-week Treasury Bills have fallen out of favor with
Of course, the amount of
currency created by monetization in a particular auction, regardless of the
percent of Treasuries purchased by the Federal Reserve, represents only a small
fraction of the monetary base.
Nonetheless, there is not only a psychological dimension but also
aggregate effects on the balance sheet of the Federal Reserve, on the US dollar
and, ultimately, on the viability of US Treasury auctions.
A general pattern of decreased
indirect bidder participation offset by rising direct bidder participation, setting
aside any increase in primary dealer purchases, is evident outside of 4-week
Treasury Bill auctions.
Foreign demand for 30-year
Treasury Bonds has fallen over the past year, suggesting that foreign purchases
may have shifted towards the short end of the maturity continuum. The more significant fact, however, is the
marked increase in direct bidder purchasing, which has more than compensated
for slack foreign demand at the extreme long end of the spectrum leaving
primary dealer purchases flat.
Given the increase in direct
bidder purchases, and reflecting on the questions raised by Messrs. Sprott and
Franklin, it seems likely that the $521.4 billion worth of US Treasuries in
2009 reflects otherwise unclassified direct bidders, i.e., direct bidders other
than recognized domestic investment funds and depository institutions. Unfortunately, the identities of the bidders
remain unknown in any case.
The most dramatic example of
primary dealer purchases replacing indirect (foreign) bidders is in Cash
Management Bills, but these represent a rolling debt of perhaps $100 billion
analogous to the corporate bond market and are not representative of other
types of Treasuries.
While there are apparent
signs of Treasury auction distress, based on a survey of Treasury auction data
from January 2009 to March 2010, there is no indication of an imminent auction
failure so long as the primary dealers and direct bidders continue to step into
the breach. Further, the same patterns
either do not appear or are much less pronounced in longer-term Treasury Note
Zhu Min, Deputy
People's Bank of China
It seems unlikely that direct
bidders within the US
can compensate indefinitely, or to an unlimited extent, for falling foreign
demand. Commenting on the ambitious spending plans of the US
federal government, Zhu Min, Deputy Governor of the People's Bank of China
said in December 2009 that "the
world does not have so much money to buy more US Treasuries."
It would certainly be
unreasonable for the US
federal government and Federal Reserve to assume that ambitious deficit
spending and ongoing quantitative easing (QE) would have no cumulative impact on US Treasury
auctions. If there is a limit to foreign
appetite for US debt, to foreign
capacity to lend to the US,
or to international tolerance for US dollar devaluation, the US government and Federal Reserve
seem determined to find it.
China's foreign exchange reserves, valued at $2,399.2 billion at the end of December 2009 (not including gold), include only $894.8
billion in US Treasury bonds. In contrast, the US
must issue or roll over $702 billion in debt in 2010 and a total of $2.55 trillion in Treasuries to be issued this year, while $3.7
trillion in US Treasuries are held abroad.
Yi Gang, Deputy
People's Bank of China
While US GDP was at $14.46 trillion in 2009 (with debt levels set to rise to 90% of GDP by 2020), China's
GDP is currently estimated as $8.791 trillion. Although
there are signs of recovery in Chinese exports, the entire value of China's reserves, assuming that
its current Treasury holdings could be liquidated, is insufficient to finance
US federal government debt in 2010.
Since China recently liquidated $34 billion in US Treasuries, the statement of China's Director of the State
Administration of Foreign Exchange, Yi Gang, "[China is] a responsible investor and in the process
of these investments we can definitely achieve a mutually beneficial
result" seems obligatory. In reality, the US
is currently the largest debtor nation in the history of the world, while China is the US'
largest creditor, and neither China
nor any other country is in a position to bail out the US should US Treasury auctions run
aground. Nonetheless, an overt Treasury
auction failure seems impossible with the Federal Reserve as the lender of last
resort to domestic depository institutions and to its own primary dealers. Unfortunately, direct monetary inflation is
not without consequences. Specifically,
increased debt monetization would impact the value of the US dollar and could
spark high inflation, i.e., rising US dollar prices for imported goods and
energy, or an eventual hyperinflationary collapse of the US dollar.
Without a robust economic
recovery in the US,
it seems unlikely that the apparent distress of US Treasury auctions will
abate. Among other things, the gap
between increasing US
federal government spending and falling
federal tax receipts is currently growing.
A continuation of current US federal government and Federal
Reserve policies under deteriorating economic conditions suggests levels of
debt that could not be absorbed by US creditors, and a so-called double-dip
recession would put extreme pressure on the US dollar. Indicators of Treasury auction distress
- Rising Treasury yields, regardless of interest
rates, signaling inadequate demand.
- A continued decline in foreign bids, thus a
higher percentage of accepted bids, particularly in additional types of
Treasuries, outside of 4-week Treasury Bills.
- Direct bids failing to rise at a rate sufficient
to offset falling indirect bidder demand, thus causing either primary
dealer purchases or monetization to rise.
- A marked and sustained increase in primary dealer
purchases versus direct or indirect bidders.
- Additional spikes in Federal Reserve purchases
(monetization) in any type of Treasury, or a sustained increase in Federal
Reserve Treasury purchases generally.
- An expansion of the incipient shift away from the
long end of the maturity continuum towards shorter-term Treasuries.
Apr 08 2010, 12:26 PM