Bond Expert: Tuesday Wrap

Prices of Treasury coupon securities took a dive from a cliff Tuesday with longer dated maturities suffering significant damage. The reason is very similar to Monday in that the market is experiencing a collective epiphany regarding the need of the US Treasury to raise funds.The yield on the benchmark 2 year note climbed 5 basis points to 1.59 percent. The yield on the 5 year note catapulted 14 basis points to 2.75 percent. The yield on the 10 year note soared 16 basis points to 3.85 percent and the yield on the 30 yield bond moved higher by 15 basis points to 4.19 percent.

The Treasury auctioned $35 billion 2 year notes Tuesday and the auction received an enthusiastic reception from investors. It stopped 3 basis points rich to levels which prevailed in the brokers market just prior to the auction. There was also a 42 percent bid in the indirect bidder column which is a proxy for central bank demand. One trader with whom I speak had observed end users selling old 2 year series paper in the 16 month to 22 month zone to take advantage of anomalies along the curve. Essentially, these investors were selling rich off the runs to buy the current issue.

I believe that next Wednesday the Treasury will announce the details of the November refunding and changes to its financing calendar necessitated by the financial bailout. Some expect that a $25 billion 3 year note will be part of the package. In addition the Treasury will probably auction $20 billion 10 year notes and about $10 billion Long Bonds.

The conventional wisdom also foresees a return to monthly 10 year notes. If that turns out to be the case and if they choose to reopen the issue sold at the refunding, then every 10 year note will eventually total $35 billion.

The 2 year/10 year curve steepened dramatically Tuesday as it climbed to 226 basis points from 215 basis points Monday. I think that reflects the markets fear of supply.

Some of the steepening of the curve would also derive from the expected outcome of the FOMC meeting Wednesday. The FOMC will probably cut rates by 50 basis points. The statement which illuminates the thinking of the members will also speak to the weakness in the economy and the strides which have been made against inflation. There will be a strong presumption of another rate cut and a very low funds rate for a long time.

Comments

[flow5:]

Debt incurred to finance transfer payments (interest, pensions, etc.) is of dubious quality.. Any enterprise, private or public, is in dire straits if it has borrowed in order to make such payments

The significant economic purposes for which a debt was contracted, or the manner in which it was financed, is of inestimatable value in evaluating it’s impact.

For example if the debt was acquired to finance the acquisition of a (new-security), the proceeds of which are used to finance plant and equipment expansion, rather than the purchase of an (existing-security) to finance the construction of a new house, rather than to finance the purchase of an existing one (as will Paulson’s planned $700 bill bailout), or to finance (inventory-expansion), rather than refinance (existing-inventories)...

The former types of investment are designated as “real” as contrasted to the latter, which constitute “financial” investment (existing homes). Financial investment provides a relatively insignificant demand for labor and materials and in some instances the over-all effects may actually be retarding to the economy. Compared to real investment,it is rather inconsequential as a contributor to employment and production.

Only debt growing out of real investment or consumption makes an actual direct demand for labor and materials.

It should be recalled that the charges on debt are related to a cumulative figure; and since the multiplier effects of debt expansion on income, the ingredient from which the charges must inevitably be paid, is a non-cumulative figure, it would seem that the time will inevitably arrive when further debt expansion is no longer a practical or possible expedient, either to provide full employment or to keep debt charges with tolerable limits.

Those who are wont to minimize the ill effects of the deficit are prone to compare the size of the deficit with nominal GDP, as if the volume of nominal GDP were independent of the size of the deficit.

Unprecedentedly large deficits “absorb” a disproporti0noately large share of nominal GDP.

Present deficits are unprecedented no matter how measured, and the past gives us no reliable guide to the future effects of deficit financing, beneficial or otherwise.

To appraise the effect of the federal budget deficit on interest rates, it is necessary to compare the deficit, not to GDP, but to the VOLUME OF CURRENT SAVINGS made available to the credit markets. The current deficit is absorbing about: research.stlouisfed.or...
of gross savings.

The more alarming aspect of the deficits is not the effect on interest rates but the effect of high interest rates on the level of taxable income and the volume of taxes required to serve a cumulative debt now exceeding $10 trillion. Both high interest rates and high taxes induce stagflation, thus eroding the tax base and increasing the volume of futures deficits.

Any deficit, by definition, creates a demand for loan-funds. The larger the deficit, the higher interest rates will be, or the less they will fall.
Any given deficit should be evaluated in terms of: (1) the size of the deficit in the context of the size of future deficits, and the accumulated debt relative to the means and costs of financing the whole: (2) how the deficit is financed: (a) from savings or (b) commercial bank credit, i.e., newly created money; and (3) the purpose for which the deficits are incurred.

Prorating the federal deficits over the entire spectrum of federal expenditures, it can be said that virtually all of the current deficits are attributable to defense spending, military and civil service pensions, interest on the debt, and welfare and unemployment benefits (& TARP). Social security for now is not include in the above list since only a very small proportion of social security benefits are financed from non-social security taxes. From an economic standpoint, only interest is “untouchable”.

If current projections of Federal Deficits materialize in this, and the next few years, interest rates (both long and short-term) will be driven up sharply by the increased demand for loan funds. I.e., any recovery in the economy will present a “Catch 22” situation. An upturn in the economy will add increased private demand for loan funds to the insatiable demands of the Federal Government. The consequent rise in interest rates will effectively abort any recovery.

Raising taxes to accomplish a reduction in the deficit would be counter-productive. Most of this debt is short-term. Combine this with the factor with the constant roll-over of some of the long-term debt and it becomes obvious that the burden of higher interest rates will be compounded. The burden becomes a function of the major portion of the debt, not just the current deficits. The burden, in fact, becomes exponential. In other words, if the trend is not stopped, the debt inevitably has to be repudiated.

It would seem that somewhere, somehow, if total net debt (not just Federal Debt) keeps rising faster than production (Real-GDP), the burden of interest charges at some point now indefinite and unknown, but nevertheless real, will become too great to carry.

2008 Oct 29 12:38 PM