Monday, June 25, 2018

The Farce That is the US Treasury Market

Today I make the case there are no longer any organic net buyers of US Treasury debt...but that yields do not and will not reflect this reality any time soon thanks to continued buying that can neither clearly be identified nor can be shown to be profitable.

But first, the global situation that has brought us to this.  The Trump trade war is not just about fair trade but about a global market that has essentially reached its zenith and all participants are fighting to maintain their slices of a shrinking pie.  As the chart below highlights, the 15-45 year old global population minus Africa (blue line) versus the annual change in that population (maroon columns).  Looking solely at the global child bearing population, that population has essentially peaked and will begin outright declining in the late 2020's.  Peak annual total growth took place way back in 1988 and has been decelerating for 30 years,  down over 90% from peak.

The chart below again shows the 15 to 45 year old global population minus Africa (blue line) but this time with the annual change in the 15-45 year old population as a percentage of the total global population minus Africa (maroon columns), the Federal Funds Rate (black line), and global debt (red line).  The relatively small annual population growth was responsible for perhaps up to 50% of the annual economic growth creating new infrastructure, housing, factories, suppliers, etc. etc.  As the population growth decelerated, interest rate cuts and debt were substituted in an attempt to maintain a centrally set growth rate.  I show the 15-45yr/old population as there is no estimation here, this population has already been born and we know its size and changes through 2035.  Of course, the fertility rates among those capable of child birth (x-Africa) are falling even faster creating a globally inverted population pyramid.

Then, focusing on America.  Again, slowing population growth has been offset by interest rate cuts and a reliance on deficit spending resulting in rising debt to GDP.  Chart below is the annual change in the 20 to 45 year old population (blue columns), federal funds rate (mirroring the change in the population), annual federal Treasury debt issued (red line), and debt to GDP (grey shaded area).  The estimated meager 20 to 45 year old population growth through 2035 only decelerates from here and is entirely reliant on ongoing immigration.  Given the large debt loads (and interest payable) coupled with minimal global and national population growth (where it matters), and the "need" to continue running large deficits to maintain the appearance of "growth"...the smart money should bet on the FFR and yields following population growth...down, down, down.

Focusing On The Treasury Market
There are four sources of potential Treasury buying; the Intra-Governmental trust fund, foreigners, the Federal Reserve, and the domestic public (insurers, pensions, banks, mutual funds, etc.).  The chart below shows the total Treasury issuance, by period, and the change in holdings by grouping, again per period.  The current period (since the Fed ceased QE) is totally unique in that 80% of buyers have ceased net buying...but rates have only nudged upward to what are still historically extremely low yields.

The Fed is selling, the IG accumulation is nearing its terminus as the boomers begin SS collection en masse, and foreigners have ceased buying US debt (on a net basis in spite of near record US trade deficits).  The surplus dollars sitting internationally, no longer being recycled into Treasury's, is akin to a cessation of the North Atlantic current...without the flow, the organic system has broken down.

Below, who among the four sources, did the buying, per period as a percentage of the issuance.  The absence of foreigners, following the Fed's exit since QE, is quite clear in the most recent period.  I'll focus on the trillions flowing into Treasury's from "domestic sources" later but first I'll focus on the IG, foreigners, and the Fed.

The Intra-Governmental Trust Fund Will Flip From Buyer to Seller, Likely by 2020
With the creation of Social Security in 1935, the trust fund surplus' were to be "invested" in government interest bearing bonds.  This meant the trust fund surplus tax revenues were spent like regular tax revenue (rather than set aside and saved for when they would be needed).  This created a mandated and ready source of buying for US Treasury debt while simultaneously also decreasing the quantity of debt that would go to "market".  The public debt (marketable) versus the intra-governmental debt (Government Account Series) below.  In 2007, the IG trust fund held 44% of all Treasury debt...meaning only 56% was actually being auctioned and rolled over in the Treasury market, helping to suppress interest rates.  However, since '07, marketable debt has surged while IG is unlikely to ever surpass $6 trillion meaning that all further US Treasury debt will be marketable.
Foreigners Follow Federal Reserve, Opt Out of Treasury's
The chart below shows the total change in foreign held US Treasury's since 2000.  The relatively consistent bid from '00 through 2014 versus the collapse in buying since 2015.

BRICS (Brazil, Russia, India, China, S. Africa) versus BLICS (Belgium, Luxembourg, Ireland, Cayman Island, Switzerland), Japan, and the Rest of the World.  Those running large dollar denominated trade surplus' (BRICS, Japan) have ceased recycling dollars into US debt.  Clearly, Russia and China are recycling much of those dollar surplus' into gold...and the like is probably true for many other nations as well.

Federal Reserve
Fed Treasury holdings, by duration, charted below.  Note the tripling of Treasury holdings since '07, but also the surge in longer duration holdings peaking in early 2014.  Of course, the Fed is now "normalizing" its balance sheet...down about 3% from peak holdings thus far in search of perhaps as much as a 50% reduction?  But the feverish buying in short durations and roll off in 5 to 10yr durations and no change to the holdings of long durations are highlighted below.

However, look at the changing durations of the Fed's Treasury holdings (below) and the impact on the 10yr minus 2yr Treasury spread.  The Fed is back to its pre-GFC holdings of less than 1yr debt, nearing the pre-GFC holdings of 5 to 10yr debt, while chock full of 1yr to 5yr and over 10yr debt.  The Fed has likely rolled off all the 5 to 10yr debt it intends to roll off, and all further Treasury reductions must come in the very short or very long durations.  Which durations the Fed begins rolling off from here is a very good question.

Domestic Treasury Buying
The subsidence of all other sources of Treasury buying means the domestic public is left to do nearly all the buying.  The chart below, with data from 2018 Treasury Bulletin, details who it is among the domestic public doing all the buying.  Not banks, not insurers, not state or local nearly all domestic buying is coming from a group called "other" with an assist from mutual funds.  According to Treasury, "other" "includes individuals, Government-sponsored enterprises, brokers and dealers, bank personal trusts and estates, corporate and non-corporate businesses, and other investors".  A historical catch all has turned into the source saving America from an interest rate tsunami?!? 
Household net worth as a % of disposable personal income has never been higher, and savings as a % of DPI has only once been lower (and just)...before the last financial crisis.  Simply put, the national DPI (the income remaining from all sources after taxation is paid) has risen far slower than assets have appreciated, and the portion maintained (as a % of DPI) has dwindled dangerously low...again.
If the Federal Reserve continues hiking, a spread inversion is dead ahead, as it has been in front of every recession since 1980.  The chart below shows the spread between the 10yr and 2yr Treasury versus the Federal Funds Rate (essentially, the cost of overnight lending) from '86 to present.  At the current spread level, an interest rate inversion (and recession) has been imminent every time since 1980.
But, this time, the spread is far more important than it has ever been.  Given the absolute dearth of domestic investible savings available and the leverage already involved to achieve the record net worth to DPI, the interest rate inversion is cutting off the last plausible source of Treasury buying.  During QE1, 2, and 3 there was a spread in excess of 250 basis points allowing and encouraging those with access to the ZIRP rates to lever up and enjoy the spread.  But at the current spread, this is no longer credible...if a profit or inflation adjusted returns are the goal.

So, the door is closing on the last believable organic buyer of Treasury debt.  The ability for private ("for profit entities") to borrow short (overnight or up to 3 months) and buy most longer durations of Treasury to achieve a profit is essentially over.  The 1 month and 3 month are already inverted to the FFR, the 6 month and 1 year will likely invert with the next rate hike, and the remainder of durations are likely to invert within the year.  The idea that banks or pensions or insurers, tasked with achieving alpha returns, would go into an unlevered trade sure to underperform inflation is pretty laughable.

This means the continued issuance of new debt in excess of a trillion annually will have no natural buyers...except for those buying without a profit motive and those not in need of selling assets to raise new cash.  Simply put, the US Treasury market is now a centrally directed farce where supply and demand no longer determine prices or is the JGB market and European sovereign debt markets...and who knows how many more.  Unfortunately, this situation will not get better...or stabilize...but will only worsen due to the demographics and population trends shown initially.  Of course, when the second most important asset (next to the crime scene that is the gold and precious metals "market") no longer is allowed to freely determine prices between willing seller and buyer, you should know everything else downstream is likewise entirely tainted.  This doesn't necessarily mean a collapse is imminent, it just means the ideals of capitalism, self determination, and democracy...the cornerstones of America...are no trusted or employed.  Make of this what you will and invest accordingly.

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