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Monday, February 23, 2015
Fundamentally Flawed - Chapter 5, Treasury Market
by Chris Hamilton, February 2015
There are four distinct classifications of Treasury
buyers. 1) Intra-government (Social Security and other
surplus trust fund tax revenues held in special Government Account Series or GAS Treasury’s). 2) Domestic pubic meaning US pensions,
insurers, banks, and all domestic retail Treasury buyers. 3) The Federal Reserve and 4) “Foreigners”.
In the two charts below, the Fed and
Foreigners have purchased the bulk of all issuance since ’09 and about 85% of all
issuance since July ’11.Domestic public primarily bought short term bills
and Intra-government purchases were special GAS securities.Federal Reserve exclusively bought mid and longer duration debt while
Foreigners purchases were varied across the curve.
Source, US Treasury A close up of buying since 2009 (below).
Source, US Treasury
Treasury accumulation by period among
the four classes of buyers (below).Public
(domestic buying) are uninterested at these record low yields (vs. institutional models premised on 6-8% returns) and Intra-governmental purchases have nearly halted primarily due to the diminishing
surplus dollars from Social Security.
Given the Federal Reserve has ended its third
round of quantitative easing (and assuming there isn’t a fourth round
upcoming?)…and deficit spending will still be the order of the day (the just ended
2014 US Treasury deficit was $790 Billion and likely to only get worse from
here), this leaves the Public, Intra-governmental, and Foreigners to maintain
the bid for new and rollover Treasury’s.But as can be seen below, the Federal Reserve’s completion of QE should
be followed by a long term process of balance sheet “normalization” from its current $4.5 trillion to perhaps an eventual $1.5 trillion balance sheet.This process of outright selling or more
likely rolling off $2.5 trillion in bonds and MBS over a 5 to 10 year period as
the “assets” mature will further increase the supply of Treasury debt over
upcoming years by $250 billion to $500 billion annually. Of course, spending money along the
way is pretty fun.It’s only when the
bills show up that reality sets in and perhaps buyer’s remorse takes over.Well, QE is like that.
QE – The Federal Reserve program of buying Treasury
bonds and mortgage backed securities.The explanation went that by creating synthetic demand (the Fed creating
money from nothing to buy Treasury IOU’s) would allow government to spend money
it doesn’t have for a real supply of debt artificially suppressing interest
rates and allowing for government spending well beyond what a “market” would
allow.And the explanation said that
soon the economy would be well and organic demand would rotate back in to buy
all the existing debt as it rolls off the Feds balance sheet as well as
maintain the bid for the ongoing newly created debt…and that this will happen
at rates that don’t bankrupt or handcuff the federal government.
A quick math problem…prior to the great financial crisis
(GFC), the Fed held about $750 billion in mostly short term bills ($500 b), a
portion in notes ($200 b), and a small portion of long term bonds ($50 b).QE began in ’08 w/ MBS and then notes and
bonds through QE1 and QE2.And then came
the Operation Twist whereby the Fed sold all the bills and shorter notes ($600+
b) and used all that revenue to buy all the longer term notes and bonds.And then QE3 got the Fed up and over $4.5
trillion on its balance sheet before the buying stopped.
Now the Fed has $4.5 trillion of mid and longer
duration notes and bonds.The Fed says
it’s going to “normalize” this balance sheet back to something like double
where it began the GFC 6 years ago…or $1.5 trillion.This means the Fed has to get rid something
like of $2.1 trillion in Treasuries and $800 billion in MBS over a period of
say 6 years (the same length of time over which the Fed purchased these).This would “normalize” the Fed’s balance and
leave the Fed with flexibility in the next GFC (assuming it doesn’t come along
too soon).However, I assume (like the
CBO) that the Federal government will continue running deficits of
approximately $800 billion annually…and this will be coupled with the Fed’s net
off-loading of $300 billion in Treasury’s annually…or $1.1 trillion annually in
Treasury debt to be purchased.
Based on the above scenario, the 3 remaining classes of Treasury
buyers (Domestic, Foreigners, Intra-governmental, and the Federal Reserve) will
be scrambling.The Fed says it is done
with QE and will be shrinking its balance sheet.Intra-governmental buying has been slowing
(as Social Security surplus’ cease and potentially become deficits).This means all net buying will fall on the Domestic
buyers and Foreigners as supply spikes.The chart below depicts what this would look like…however there are only
two likely scenarios under which the domestic public will step in…
Interest rates spike making the yields a
relatively attractive investment for domestic institutional buyers such as
insurers, pensions, banks, retail, etc…but a return to the 50 year average of 7%
blended yields on $18 trillion in debt would mean 1/3rd of all
federal tax revenue ($1.25 trillion) would simply be paying interest on our
debt…and much of it flowing to foreign buyers without any velocity or
multiplier within the US economy.
The stock market and real estate collapse making
any yield, even a 1% 10yr Treasury, a relatively good investment.Under this prospect a strong bid from the
domestic public might be reasonable but the economic impacts of this scenario
are simply too ugly to entertain.
However, if the
stock market remains at anywhere near its current heights, bonds at record low
yields, it is entirely ludicrous to believe domestic buyers would increase
their buying by 1000% over the next three to six years.
So, the last
resort (absent the Fed restarting QE) is the foreign bid doubling or tripling
over the coming years.And this
means our nation’s fate is comically in the hands of our recent largest
creditors…Luxembourg, Ireland, Belgium, Japan, and the Cayman Islands…and
pretty safe bet these nations nor their inhabitants are any more interested in
US treasury’s than the domestic buyers within America.So, all that is left in this silly tale is
central bank buying hidden in off shore locations to keep the facade of a
Again, below the Domestic Public is left to
shoulder the vast majority of the debt plus the bulk of roll off from the
Federal Reserve balance sheet (below).This means there will be 122% to be purchased over the next four
years…100% plus the additional 22% supply from the Federal Reserve.
Source, US Treasury
But this no win scenario of the domestic public
forced to buy all Treasury debt at low rates (and go bankrupt due to the nearly
zero yields) or buying it at high rates (bankrupting the federal government in
interest payments) or not buying at all forcing the Fed and “Foreigners” to
continue buying it all at progressively lower rates…well it seems ludicrous and
yet those are the choices before us.If
you chose the last option, you are not alone.That is actually the only politically viable option.And so, how is this being done???