Mises Daily Articles
Obama Says Short US Treasuries
Bank bailouts, homeowner bailouts, auto-industry bailouts, and now massive stimulus packages; the federal government spending list goes on and on.
Goldman Sachs projects the federal deficit for this fiscal year to be as high as $2.5 trillion. That's 5.5 times the fiscal 2007 federal deficit and 1.5 times gross US savings.
A $2.5 trillion deficit will create quite a waterfall on this graph, don't you think:
And according to our president, there is more "water" to come. Starting with his first address to a joint session of Congress, as recapped by Hans Nichols and Juliana Goldman in a February 25 Bloomberg article, we learn:
Obama Casts Crisis as Chance to Overhaul Banking, Health Care
President Barack Obama framed the U.S. economic crisis as an opportunity to solve some of the nation's most intractable issues …
"The cost of action will be great," he said. "I can assure you that the cost of inaction will be far greater." …
Obama … called for sweeping initiatives on energy, health care and education, saying they are "absolutely critical to our economic future." …
"History reminds us that, at every moment of economic upheaval and transformation, this nation has responded with bold action and big ideas," he said.
Not limiting these "bold ideas" to merely energy, health care, and education — and to win universal support — Obama concluded by promising money for everyone:
I will not spend a single penny for the purpose of rewarding a single Wall Street executive, but I will do whatever it takes to help the small business that can't pay its workers or the family that has saved and still can't get a mortgage… That's what this is about. It's not about helping banks — it's about helping people.
Then, on February 26, we see this headline on the MarketWatch website: "Obama unveils far-reaching $3.6 trillion 2010 budget…while predicting big deficits."
Such is the mindset of this president, this government, and, it seems, the majority of the voting public. Never let a good crisis prevent you from expanding the role of government. This is shaping up as the biggest expansion in government since the days of FDR and LBJ.
What impact will this spending extravaganza have on US Treasury interest rates? So far, it seems to have had little impact.
The impact on US Treasury rates in the future? In the final analysis, it will depend on how this spending extravaganza is funded.
Funding can come from only three places:
- Higher government taxes
- More government borrowing
- More, freshly printed Federal Reserve notes, if that borrowing is monetized by the Federal Reserve
First up, taxes. The recently passed stimulus packages have no new taxes. To the contrary, they will be providing "middle class" tax rebates. And while Obama's 2010 budget proposal includes new taxes on the "rich," its revenue potential, though estimated at $640 billion by the administration, is likely to be far less. Why is that? Higher tax rates discourage entrepreneurs from starting new business ventures and expanding existing ones. They discourage the marginal worker from taking overtime, or a spouse from seeking employment to help with the family budget. Combined with unemployment insurance, they may even discourage an unemployed worker from seeking new employment.
And, most importantly, higher tax rates discourage people from saving and investing, especially when such taxes target the rich. They deprive the economy of the funds necessary to grow production, income, and employment. Without these people, at the margin, there is no new tax revenue. Besides, when is the last time the government met a revenue projection? Suffice it to say, the funding for these new spending programs will largely NOT be coming from taxes.
Enter option two, more government borrowing. This will place the government's funding burden directly on the credit market and put upward pressure on US Treasury rates. How much pressure?
Let's start by sizing the funding take relative to US savings. Fourth-quarter federal debt was $10,700 billion — nearly 7 times US gross savings. From a historical perspective, this is already a big take.
Adding another $2.5 trillion to the debt, at the same savings rate, yields a debt to saving ratio of 8.5, more than double the level of the last 20 years. Yes, a very big take.
But there's more. It just so happens that those pay-as-you-go government trust funds, the ones with some $50 trillion in unfunded liabilities, have been a big help in funding the government's borrowing needs for years. Why is that important? Because it means the government did not have to tap the credit markets, the public, for the full amount of its funding needs. In the fourth quarter of 2008, government trusts held 40% of the federal debt, 1.4 times 1990 levels and about double the levels seen in the 1960s, 70s and 80s.
Unfortunately, that help is waning, because the aging baby boomers, now entering retirement, are about to turn this positive dynamic into a very large negative for the federal government and its borrowing costs. Pressed by declining "contributors" relative to growing beneficiaries, the trust funds' contributions to the federal government's funding needs could very well have peaked at 44% of gross federal debt in the second quarter of 2008. Demographics suggest it's likely.
That means the public credit markets will increasingly be the source of funding for the federal government. Public held debt front and center. Let us first look at some trends:
Can we say parabolic? With public held debt already at a spiking 4.1 times gross US savings and an even more eye-popping 23 times net private, state and local savings, one should expect even more upward pressure on US Treasury interest rates as our spend-happy government is forced to expand its take of the public credit market.
These are pretty big spikes, you say. Forget going forward. Why are US Treasury rates still plumbing historic lows? Give a big thanks to foreign investors and central banks. They do so love US Treasuries. Here's the historical record of foreign holdings of Federal Debt:
That's right, over 50% of the public held federal debt is owned by foreign investors and central banks, twice as much as in the 1990s and ten times as much as in the 1960s. In fact, in this decade, foreigners have absorbed nearly 80% of the government's public debt offerings. Clearly, without China, in fact all of Asia, the BRICs, and the Middle East too, US Treasury rates would not be at historic lows.
Which leads back to an examination of US savings. If foreign buyers have taken 80% of the government's borrowing needs this decade, then, by definition, US buyers have taken just 20%. Consider this: if foreign buyers back away, could US buyers fill the void? Does the US buyer have the savings? Sad to say, and well-documented by numerous analysts, the US savings rate has been going down, for years. The buy-now-pay-later mentality has put the US in debt up to it ears. And the prospects going forward are not so encouraging. Witness
- a US consumer facing the prospect of rising job layoffs and higher cost of living;
- falling business profits and retained earnings, reflecting the weakening economy;
- mounting state and local deficits, reflecting falling income and property tax revenue;
- a Federal Reserve discouraging savings by stubbornly holding interest rates near zero;
- and now, a Federal Government hell-bent on making things worse by raising tax rates on income and capital.
In other words, don't expect a lot from the US investor, certainly not at these low interest rates.
Now consider this: what if foreign buyers back away, at least with respect to new purchases? Yes, I know, you have heard this before. No one is going anywhere. The foreign buyer is here to stay. Consider these observations by Naufal Sanaullah in his recent essay, The Future of Gold:
Foreign nations don't have the means or will to continue financing our debt. Commodity prices have collapsed, cutting deeply into foreigners' export revenues. Oil is down from highs around $150/barrel this past summer to around $40/barrel now.
And with respect to the all important Chinese, Sanaullah has this to say:
In November, China announced a $585 billion economic stimulus package to be fully invested by the end of 2010. The Chinese government agreed to provide only $170 billion of the funds. How will China raise the other $415 billion for continuous use until the end of 2010? Surely, local governments and private banks and businesses can't finance such a large package in the midst of a historic recession.
The only reserve China can tap into to finance its stimulus package is its $1.9 trillion foreign exchange reserves, $585 billion of which is in US Treasury securities. Financing its stimulus package would require selling Treasury securities
As Sanaullah points out, given "the political and even militaristic consequences," China may not sell its holdings, but "what seems certain…is that China can no longer purchase more American debt to finance the US Treasury."
China, of course, is not the only foreign buyer at risk. Sanaullah sums up the state of the US Treasury's largest remaining foreign creditors:
Japan is facing enormous headwinds as its quality-focused exports are suffering massive demand destruction as its consumers abroad lose wealth at epic proportions….The British demand for American debt represented Middle Eastern oil-financed investment, but with oil prices collapsing, it will be next to impossible for this proxy demand from the UK to rise and finance additional debt. The demand for US debt by Caribbean banking centers is because of their tax laws but as the credit crunch leads to liquidity destruction in Caribbean banks, these banking centers will no longer be able to buy additional debt. OPEC nations' US debt demand, similar to the UK's, is tied to Middle Eastern oil revenues financing American consumption (of their oil exports). As oil prices tank, so will OPEC nations' economies and they too will have no wealth to buy up more American debt.
Sanaullah may be right. I would add that it is not just about "foreign nations not having the means or will to continue financing our debt," but also about debt-laden US consumers not having the means or will to continue consuming foreign products. For years the US has printed money in return for foreign goods, with foreigners recycling those dollars right back into US Treasuries. We could be nearing the end of this virtuous cycle.
For you skeptics, this is not just a theoretical argument. We may be seeing an inflection point developing now. Have you seen the shape of retail sales lately? More to the point, feast your eyes on a possible turn in the US current account figures:
Mark the crash in US imports:
Before leaving this thread, there is another important trend that must play out before we can declare the foreign buyer as no longer in the game. Foreign central banks want out of Fannie and Freddie, and it looks like the United States has "obliged," buying back those agencies in return for a show at US Treasury auctions. According to the Federal Reserve's H.4.1 release, on July 16, 2008, foreign central banks held $985 billion in US government agencies, up from about $150 billion at the start of the housing bubble. As of February 25, 2009, they had reduced those positions to $813 billion. Over that same period, those same foreign central banks bought about $400 billion in US Treasuries. An upgrade, perhaps, but clearly a positive for US Treasuries these last 6 months. Agency sales have been slowing of late, but this trend could have a bit more to run. On the other hand, when the run is over, this will put more pressure on US Treasury interest rates.
Where does that leave us? In Sanaullah's words, it leaves us with option 3, monetization, because
[w]ith an insolvent public and no foreign demand for Treasuries, the Federal Reserve will monetize debt to finance its continued bailouts and economic stimulus.
If this taxing and borrowing gets too hard, why not issue government IOU's and have the Federal Reserve buy them with money printed out of thin air? That way the federal government gets it's financing — and at continued low rates. Indeed, if foreigners back off, given the sorry state of US savings, what choice will the Federal Reserve have?
This may work for a while and keep US Treasury rates contained. The problem is that money printing means reducing the purchasing power of the dollar. In other words, price inflation. When investors begin accounting for this inflation in their buying decisions, the inflation premium demanded by US Treasury buyers will cause US Treasury interest rates to rise, and rise in earnest. And who are among the most US dollar sensitive market participants in the world? Foreigners. And who is the biggest marginal buyer of US Treasuries? The foreign buyer. This is an unprecedented dynamic in US history. Add this dynamic to these disastrous spending, saving, and funding dynamics, and we could see US Treasury rates explode.
You say: deflation is the concern now. There's no reason for any inflation premium. That's tomorrow's worry. US Treasuries are the safest asset in the world! Investors, foreign and American both, would not be piling into US Treasuries if they were worried about inflation. And you would be right. No one is worried about inflation. Everyone is worried about safety. And that's precisely the point. I say, safety from what? If you are a contrarian, that should tell you something. Do I hear crowded trade?
What's this? Maybe those dollar-sensitive foreign buyers are beginning to see the point, and are making some "adjustments." In the recent essay, Bill Bonner writes,
We are bearish on U.S. government paper — in all its forms. And here's why. The latest estimate from Goldman Sachs puts U.S. government borrowing for this fiscal year at $2.5 trillion. Meanwhile, foreigners are showing less and less interest in U.S. debt. They're switching to short term paper — bills and notes, which are less vulnerable to inflation and currency declines… [emphasis added]
Steve Saville, one of my favorite analysts and proprietor of The Speculative Investor, believes gold may be helpful in flagging the point where deflation concerns abate and worries over inflation return. I agree. To start, a gold price break above the March 2008 highs would perhaps signal that inflation is back.
Bonner, in another recent essay, "The United States: The Largest Ponzi Scheme in the World," seems to agree. He recaps the conundrum the US Treasury buyer faces, and by extension how close we may be to much higher rates on US Treasuries:
What is odd is that while gold goes up, so does the dollar. And so do U.S. Treasury bonds. It is as if investors couldn't make up their minds. They bid up the price of U.S. Treasuries … and bid up the price of anti-Treasuries at the same time. What gives?
On the right side of their brains, they figure that U.S. Treasury bonds are the only place you can put your money and be sure of getting it back. Stocks are a disaster. Bonds — except for U.S. Treasuries — are too risky … Commodities? We've seen what can happen there … Even gold could easily take a 20% haircut.
But wait … the left side of the brain is sending a message too. Buy gold, it says; something fishy is going on in the Treasury bond market… How is it possible that the feds can borrow trillions of dollars without causing interest rates to rise? How can they increase the quantity of something so much … without lowering its quality?
One question leads to another one: 'How are they going to pay this money back?' the left side wants to know.
The more the left side thinks about it, the more it doesn't understand what is going on. Let's see … the biggest spendthrift on the planet issues trillions more in IOUs … with no obvious way to pay back the money … and let's see … this same spendthrift actually has the right to pay off its IOUs with more IOUs that it prints up itself … and it actually WANTS to make its IOUs less valuable … so that people won't hold on to them. It wants people to spend its IOUs on goods and services … as fast as possible … in order to "get the economy moving again."
Bonner concludes that
[t]he fearful world is buying Treasuries, but not because the tax revenues of the American state are so reliable; they're buying Treasuries because the United States is the only substantial debtor in the world that can make good on its debts with money of its own making… The only way to pay off the old lenders is to bring in new ones — or run the printing press. That's all lenders have to worry about — inflation. And for the moment, prices are going down.
Yes they are, until, as Bonner says, "they start going up."
Before I wrap this up, one more table to underscore these points, this one showing federal debt held by the Federal Reserve:
Note the decline in Federal Reserve debt held as a percent of public debt held, beginning in the 1980s, which is about the time foreign buyers began stepping up. Note also the largest percentage take occurred in the inflationary 1970s. Most importantly, observe the plunge in Federal Reserve debt, in dollars and as a percent of publicly held debt, in the fourth quarter of 2008. In fact, from a peak of $790 billion in the third quarter of 2007, Federal Reserve holdings of US Treasuries are off 40%. While foreigners were buying US Treasuries in size, the Federal Reserve was selling US Treasuries in size — in exchange for agency debt, mortgage debt, consumer debt, and other toxic paper.
Now, look at what the Federal Reserve has done to its balance sheet, despite the help of foreign US Treasury buyers:
Do we already have inflation in the pipeline? I think so. Imagine what the Federal Reserve's balance sheet — and inflation — will look like when the Federal Reserve has to step in and monetize the federal debt too. Now if that doesn't put an inflation premium into US Treasury rates, nothing will.
My thinking is to short sell US Treasuries. Maybe it's a bit early, especially if we have another deflation scare, but if you are not already in at these historically low rates, scaling in — building a Treasuries position over time, starting now — may not be such a bad idea.