Wednesday, February 21, 2018

Who Will Buy Those Trillions of US Treasurys???

As of the latest Treasury update showing federal debt as of Wednesday, February 15...federal debt (red line below) jumped by an additional $50 billion from the previous day to $20.76 trillion.  This is an increase of $266 billion essentially since the most recent debt ceiling passage.  Of course, this isn't helping the debt to GDP ratio (blue line below) at 105%.

But here's the problem.  In order for the American economy to register growth, as measured by GDP (the annual change in total value of all goods produced and services provided in the US), that growth is now based solely upon the growth in federal debt.  Without the federal deficit spending, the economy would be shrinking.

The chart below shows the annual change in GDP minus the annual federal deficit incurred.  Since 2008, the annual deficit spending has been far greater than the economic activity that deficit spending has produced.  The net difference is shown below from 1950 through estimated through 2025 based on 2.5% average annual GDP growth and $1.2 trillion annual deficits.  It is not a pretty picture and it isn't getting better.

Even if we assume an average of 3.5% GDP growth (that the US will not have a recession(s) over a 15 year period) and "only" $1 trillion annual deficits from 2018 through 2025, the US still continues to move backward indefinitely.

The cumulative impact of all those deficits is shown in the chart below.  Federal debt (red line) is at $20.8 trillion and the annual interest expense on that debt (blue line) is jumping, now over a half trillion.  Also shown in the chart is the likely debt creation through 2025 and interest expense assuming a very modest 4% blended rate on all that debt.
So, for America to appear as if it is moving forward, it has to go backward into greater debt?!?  If you weren't troubled so far, here is where the stuff starts to hit the fan.

With the change to the Unified budget, effective as of 1969, the Social Security surplus was "unified" into the federal budget.  The government gave themselves a ready buyer for US debt while simultaneously allowing the SS surplus to be spent in "the present".  Congressionally mandated to buy US debt, from 1970 to 2008, the Intra-Governmental Holdings (over half from the Social Security surplus) purchased over 45% of all federal debt issued.  This meant "only" 55% of US debt was auctioned into the market, or "marketable debt".

But the annual SS surplus has declined by 90% (from over $200 billion a year at the peak in 2007 to perhaps $20 billion this year) and, according to the SS trust fund, the last surplus will be recorded in 2020 or 2021.  After that (or essentially now), the Congressionally mandated buyer (which consumed almost half of all US federal debt for 4 decades) will cease.  Not only will the IG Holdings no longer be a buyer, they will need additional debt created to make good on those $2.9 trillion in SS "reserves"...and all the debt issued will be "marketable".

The chart below shows the "marketable" debt vs. IG Holdings from 1970 through 2025.  As noted above, IG consumed nearly half of all US debt up to 2008...but since '08, IG has consumed just over 10% of all the new issuance and nearly 90% of new debt been auctioned into the market.  IG has essentially ceased to be a buyer...meaning that marketable debt will continue to soar.
So who is a buyer of US Treasury debt?  Only three possible groups remaining; "foreigners", the Federal Reserve, and private domestic sources (pensions, banks, mutual funds, individuals).

I will show that foreigners have essentially ceased buying, that the Federal Reserve isn't a buyer and in fact is reducing its balance sheet...and this means there is only one buyer remaining to soak up the surging marketable debt.

But before I detail these...I want you to remember Harry Markopolos.  Markopolos is a financial investigator and he gave clear evidence of Bernie Madoff's Ponzi to the SEC as early as 2000, again in 2001, and again in 2005.  The SEC did not see what they didn't want to see and it wasn't until the great financial crisis of '08 that Madoff's fraud was exposed and the loss of approximately $65 billion realized (below, from Wikipedia).
  • When Markopolos obtained a copy of Madoff's revenue stream, he spotted problems right away. Madoff's strategy was so poorly designed that Markopolos didn't see how it could make money. The biggest red flag, however, was that the return stream rose steadily with only a few downticks—represented graphically by a nearly perfect 45-degree angle. According to Markopolos, anyone who understood the underlying math of the markets would have known they were too volatile even in the best conditions for this to be possible. As he later put it, a return stream like the one Madoff claimed to generate "simply doesn't exist in finance." He eventually concluded that there was no legal way for Madoff to deliver his purported returns using the strategies he claimed to use. As he saw it, there were only two ways to explain the figures—either Madoff was running a Ponzi scheme (by paying established clients with newer clients' money) or front running (buying stock for his own account, based on knowledge about his clients' orders).
With that in mind and the largest single buyer (IG) now a seller, let's look at the remaining "buyers" and consider the nearly $21 trillion US Treasury market:


Federal Reserve...presently allowing Treasury bonds and MBS (mortgage backed securities) to mature, reducing it's balance sheet on a monthly basis.  The Fed plans to roughly halve its balance sheet from $4.5 to $2.2 trillion between now and 2022 (a $250 billion annual reduction in Treasury holdings).  That is a net increase of available Treasury debt of $250 billion annually above and beyond the trillion plus in new issuance and trillions being rolled over every year.

Foreigners...foreigners presently hold $6.3 trillion in US Treasury debt but since QE ended in late 2014, foreigners have essentially gone on strike, adding just $150 billion in a little over three years (chart below).

Foreigners added an average:
  • '00-->'07 +$160 billion annually
  • '08-->'14 +$540 billion annually
  • '15-->'18 +$50 billion annually
The current pace of foreign Treasury buying is less than 1/3 the pace of the early '00's and a 90% reduction from the pace of '08 through '14, when QE was in effect.
Just three buyers hold over half (55%) of all debt held by foreigners; China, Japan, and what I call the BLICS (Belgium, Luxembourg, Ireland, Cayman Island, Switzerland).  The chart below shows each nations/groups US Treasury holdings from '00 through December of '17.  Entirely noteworthy:
  • China '00-->'11 +$1.2 trillion...but China has been a net seller of Treasury's since the July of 2011 debt ceiling debate
  • Japan '00-->'11 +$600 billion...Japan's holdings did rise after the July 2011 debate but are fast declining now toward the same quantity it held in July of 2011
  • BLICS '00-->'11 +$300 billion...It has been the $800 billion surge in BLICS buying since July 2011 that has kept foreign demand alive.

As for the BLICS, their buying patterns since '07 have grown increasingly bizarre, as if profit isn't their motive?  However, if maintaining a bid for US debt is the motive, the massive surges in buying at the worst of times makes sense.

So, I've shown US federal debt is surging but the only thing keeping the US economy "growing" is the size of the deficit and debt incurred.  I've show the traditional sources of net Treasury buying have ceased except for the domestic public.  That the Intra-Governmental holdings are essentially peaking and will be a net seller within a couple years and all new debt issued will be "marketable".  I've shown the Federal Reserve plans to "roll off" approximately $250 billion a year for up to four years.  I've shown that China ceased net buying Treasury debt in 2011 and foreigners have essentially gone on strike since QE ended.  The only real foreign bid remaining is from some pretty shady demand that looks an awful lot like it could be central bank buying, but regardless the BLICS, foreign demand for Treasury's (on a net basis) has essentially stopped.

This leaves the domestic public to purchase all the surging new issuance, plus the portion the Fed (and soon enough, the IG) is rolling off, and with little to no assistance from foreigners (even the possibility the strike turns into an outright selloff!?!).  The domestic public currently holds about $6 trillion in Treasury debt and will need to buy in excess of $1.5 trillion annually (indefinitely) between picking up the roll off and the new issuance.  If the public "willingly" do this at low interest rates, it will represent 7.5% of GDP going toward Treasury purchases that yield well below needed returns.  If the Public don't do this "willingly", interest rates will soar far more than shown above and the US will be overwhelmed by debt service.  The only other option is that the Federal Reserve makes a U-turn to re-start QE and openly engage in endless monetization.

Some articles with further and slightly different details on much of the above.(HERE) (HERE) (HERE)

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