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.
Source, Treasury
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…

  1. 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.
  2. 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 market alive. 

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???

And that is a great segue to chapter 6…