More Debt, Less Filling 26 comments
James Picerno
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The selling of the 10-year Treasury Note (and the corresponding rise in yield) since December 31 is still just a blip, but is it a blip of things to come?
The 10-year's yield closed yesterday's session at roughly 2.5%. Yes, that's still historically low, although it's up from the 2.04% low touched last month. Noise, perhaps, although some of the noise of late sends a suspicious mind wandering.
That includes the echoes reverberating from Thursday's advisory in the New York Times: "China Losing Taste for Debt From U.S." In the current climate, when the U.S. government is pulling out all the stops to spend money, and sell Treasuries to fund the plan, it's hard to ignore a headline casting doubt on America's single biggest source of lending these days.
“All the key drivers of China’s Treasury purchases are disappearing — there’s a waning appetite for dollars and a waning appetite for Treasuries, and that complicates the outlook for interest rates,” Ben Simpfendorfer, a Hong Kong-based economist at the Royal Bank of Scotland, tells the Times.
'Complicates' is a somewhat ambiguous reference, although we all know what he means. Rates may be inclined to go higher at some point. Perhaps not yet, perhaps not for a long time. But in the long run, it's hard to see how the boys in Washington can engineer another outcome. True, that and 50 cents will get you a cup of coffee when it comes to searching for profitable trades for next Tuesday. But if you're inclined to gaze a bit further into the future, there's quite a bit of meat on this bone.
Then there's the story's reference to a senior central bank official in China, who reportedly said late last year that the Middle Kingdom's foreign exchange reserves kitty has been doing the unthinkable lately: dwindling. It's no great surprise to learn that the great wall of exports flowing from China is slowing, given the current economic climate in the global economy. But if this is a trend with legs, there's going to be trouble ahead in bond land, perhaps more than the casual observer of the financial scene recognizes.
But, wait — there's more. Much more. Debt, that is. The Congressional Budget Office projects that the federal deficit will reach an unprecedented $1.2 trillion, or 8.3% of GDP, as the chart below shows. In testimony yesterday to Congress, acting CBO director Robert Sunshine delivered a message in direct conflict with the imagery that his surname conjures: "The major slowdown in economic activity and the policy responses to the turmoil in the housing and financial markets have significantly affected the federal budget," he advised. "As a share of the economy, the deficit for this year is anticipated to be the largest recorded since World War II."
click to enlarge
Is it any wonder that holders of government debt, here and abroad, might be feeling a bit skittish?
As we wrote on Tuesday, the mounting debt load, current and future, on the U.S. government is old news, but it has legs. For the moment, those legs keep getting longer and stronger. Before this is all over, this story may be running on stilts.
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This article has 26 comments:
The Federal Reserve's data on consumer credit shows dramatic contraction, we know that few auto loans are being written, few mortgages are being written, very little mortgage equity withdrawals are occurring, corporate bond issuance is at multi-year lows, and the commercial paper markets basically stopped providing credit without Federal assistance.
Thus, much of the increasing public debt appears to be offsetting a decline in private debt. That's not to say they're the same thing: one is backed by the full faith and credit of the US taxpayer, and the other isn't-- but in analyzing the system as a whole, its worth considering that the overall debt levels in the economy taken in aggregate are not rising as fast as the Federal data indicate.
I think the point of the article is that the _public_debt is also fast losing its market. The fear is that what happened to _private_debt may soon end up happening to public debt as well - no buyers. The question then would be: Now what?
Good point nonetheless.
Somehow I doubt this.
>
> I think the point of the article is that the _public_debt is also
> fast losing its market. The fear is that what happened to _private_debt
> may soon end up happening to public debt as well - no buyers. The
> question then would be: Now what?
The point about private debt collapsing is that the demand for public debt may not be "fast losing its market". At this moment, no one wants to hold anything much except Treasuries. The drop in demand for private debt instruments means that, unless people convert their capital into some other form -- which they're clearly not doing-- there will be a commensurate rise in demand for Public debt.
There's been no great flow into the Euro, the Yen, or the Yuan, no significant flow into US or any other equities, no flows into real estate. So basically there's a vast pool of money that doesn't want to invest anyplace, and is sitting in cash . . . which means they're in Treasuries.
If there were no buyers for public debt: Where does the money go? If you're holding cash in your brokerage account, you're holding Treasuries (indirectly). Seems to me that Treasuries can't fall until some other asset class begins to see a massive flow of money in . . . and that just isn't happening (yet).
Private debt is contracting because people are losing their jobs and/or afraid of same. The FY 2009 US Federal deficit is estimated to be $1.2 Trillion, not counting any stimulus package, in part because tax revenues are down vs projected caused by the economic fall.
So why do Treasury buyers have confidence in the US government's ability to pay off debt? Deficits are historic and rising with no end in sight. Maybe they're not thinking it through. Where will the tax revenues come from to pay off these new Treasuries? There may be a current surge in demand for "public debt" but I believe it is short-sighted. Yes, all that money fleeing stocks has to go somewhere. I am starting to think that it is rolling around the gun deck like a loose cannon.
On Jan 09 10:48 AM SW Richmond wrote:
> Crocodilian,
>
> Private debt is contracting because people are losing their jobs
> and/or afraid of same. The FY 2009 US Federal deficit is estimated
> to be $1.2 Trillion, not counting any stimulus package, in part because
> tax revenues are down vs projected caused by the economic fall.<br/>
>
> So why do Treasury buyers have confidence in the US government's
> ability to pay off debt? Deficits are historic and rising with no
> end in sight. Maybe they're not thinking it through. Where will
> the tax revenues come from to pay off these new Treasuries? There
> may be a current surge in demand for "public debt" but I believe
> it is short-sighted. Yes, all that money fleeing stocks has to go
> somewhere. I am starting to think that it is rolling around the
> gun deck like a loose cannon.
Think about how much of the increase in public debt is merely a substitution for private debt.
As one example, consider the "Commercial Paper Funding Facility". The commercial paper market basically shut down early in the fall . . . much of the increase in Federal debt is substituting a Government credit for a private credit. At the point that people are willing to fund commercial paper, the corresponding balances in the "Commercial Paper Funding Facility" will fall.
The economy has finite needs for credit. At this point, much of what is happening is that private indebtedness is falling, and public indebtedness is growing. Moreover, the interest rate on the aggregate debt is plummeting, as Treasury securities are yielding very close to nothing. . . let us hope the Treasury can sell as many 30 year bonds under %3 as they can . . . that will be an incredible bargain for the taxpayer.
We are having to borrow billions of dollars every day to replace the capital we are sending out of the US.
We will not be able to continue to do this for much longer.
I started my analysis here with four assumptions:
1. When and whether foreign central banks start dumping Treasuries, or stop buying them, is largely unknowable.
2. When and whether there is an economic recovery in the US is likewise unknowable. However, if one doesn't begin within 7-10 years, there may never be one, and in any case the relevance of the US to the global economy will be permanently reduced (for knee-jerk permabulls: I am not saying the world will end. Please read carefully).
3. The yield curve will not invert while the Fed is printing.
4. Supply will remain extremely elevated across the curve for at least the next two years.
Together, all of these assumptions strongly point to steepening, and suggest that shorting the 30-year bond is the best way to make money regardless of the timing of any recovery and/or loss of foreign central bank confidence. Furthermore, within the next 10 years, one of those outcomes is nearly inevitable, and each means higher yields. So given that we've chosen to short the long bond, that (if our assumptions are correct) we are guaranteed to make money on this trade, and that the cost of borrowing right now is minimal, the solution to our first question is clear:
Short the Long Bond NOW.
In fact, I've been short for a long time now, and recently tripled my position when yields were below 2.8%. But it's not too late. You just have to decide whether my three assumptions are reasonable. If you're inclined to think not, I'd like to know: if you're holding long bonds at 2.6-3.0%, exactly what are you hoping for? More weakness? At some point, sufficiently severe continuing weakness will have three impacts, all of which are bearish for bonds: it will erode the tax base on which the Treasury relies for making payments on debt (increasing the risk of default), it will increase supply as the government becomes increasingly desperate to provide more bread and circuses, and it will tighten the supply of available dollar reserves outside the US. The only mitigating factor would be a huge supply of cheap money and plentiful fear of other dollar-producing assets. But at some point one has to believe those dollars would start getting sold for (presumably less doomed) foreign assets instead of sitting in Treasuries. In fact, we are seeing some very modest and very early signs of all of these trends already. That's why I consider this a no-brainer trade. If you can afford to wait years for certain profits, you might as well start positioning yourself now.
We can now turn our attention to the double bonus question. If we're going to short the long bond, what should we do with the dollars we get? This question is actually much more difficult because it depends a great deal on the exact amount and timing of US weakness and the specific responses of numerous governments and central banks as well as production and consumption patterns. The coward's answer is to simply hold more of the asset one holds when no other option seems good, which of course is gold. This is a fine, low-risk option that should work well no matter how you measure your profits (I measure mine in gold, but others often use their home currencies - an increasingly dangerous but still common error). But I think it's possible to do better. There are two basic scenarios possible: the global economy recovers and resumes robust growth (possibly with a different balance and leadership structure, possibly not), or we enter a multi-century period of mean reversion. The important observation here is that unless you are managing money for a university endowment, the second scenario is irrelevant. Your life is going to get materially worse no matter what you do; as we saw above with Treasuries, if the global economy contracts steeply enough for long enough then even those assets at the bottom of the financial pyramid can lose real value. In this scenario, even gold will lose some of its purchasing power, and everything else will do worse. So ignore that and let's look for some upside. In addition to gold (limit downside risk), I would want to own a mix of urban and near-urban real estate assets near major global cities, stocks in major technology and consumer goods companies in China, Brazil, and southeast Asia, manufacturers of transportation products (buses, railcars, locomotives, steel), and oil and gas. The basic premise here is that there are still billions of people in the world who are subsistence farmers. Many of them will not be subsistence farmers in 100 years, except in the doomsday scenario we chose to ignore. They probably won't be living in the US, driving cars to work every day, or eating cheese, but their lifestyles will be changing in somewhat predictable ways. And their governments will be selling their surplus dollars to manufacturers of the kinds of products mentioned above in order to support those changes.
There aren't any earth-shattering or genuinely new ideas here, and for that I apologise. But I find it helpful on occasion to review my thinking about long-term trades in the context of what we've learned lately. And in this case, I find myself more inclined than ever to position myself as described here, even though people have been talking about some of these trades for years already. Remember, even if you're wrong on the long leg, you'll still make money on the short side. Maybe the US stages a dramatic recovery in 2H09 and retakes the global lead with a vengeance. Your long portfolio won't look too special in that case (though you'll probably profit anyway). But 30-year yields will probably rise back to at least historical norms in the 6-7% range, so you'll turn a huge profit there. Bottom line, it's looking very difficult to go wrong shorting the long bond right now against anything with low or negative correlation to the US, if you have a sufficiently long-term outlook. Not because it's impossible for yields to go lower but because it's impossible for yields to go lower and stay there for 30 years.
Thoughts anyone?
Are we on our way to becoming like Russia,China, or India? Whenever we think the government spending is short term we always find out we are badly mistaken. Wasn't Iraq and Afghanistan suppose to be a sort term cost? Wasn't TARP suppose to solve everything. TARP like spending is looking to be here every year until 2012.
According to doomsayers that's when the world ends lol...
"1. When and whether foreign central banks start dumping Treasuries, or stop buying them, is largely unknowable."
True. If they stopped buying Treasuries, what would they buy? What would the effect on their own currencies and economies be of such a decision?
"2. When and whether there is an economic recovery in the US is likewise unknowable."
Also true. However, a review of US economic history would suggest that there will be a recovery. I'm not aware of a situation in world history where a civilization simply went into economic decline and failed, without war or pestilence. To the extent that we're presently "at war"-- its a war of choice, and we can decide to end it.
"4. Supply will remain extremely elevated across the curve for at least the next two years."
Supply of Treasuries will remain elevated-- however, aggregate supply of debt will remain constant, or perhaps even fall. At the point that private entities can issue their own debt, supplies of Treasuries will fall.
@daniel3582
"I think we are going to see that money (in some part) flood into commodities later this year, particularly oil."
Well, you have a lot of company in that belief. The oil market itself "says" that, with pricing in contango (futures priced higher than the spot, the opposite of what's normal for oil . . . priced so much higher that people are parking tankers full of oil to wait for higher prices).
However: if you believe that oil will rise, implicit in that belief is an economic recovery (or supply destruction, but that operates over a longer timeframe). Given the oil consumption/stockpile numbers, its hard to see how oil can go up in the 12-18 month timeframe without an increase in consumption, which equates to an increase in economic activity.
This may sound strange to you, but what you wrote here just proved my point, IMHO. Most people are not having cash sit in their brokerage account - they are de-leveraging by paying off as much debt as they can, and are thus increasing the savings rate in our country. This will probably result in a devaluation of all asset classes as most investments have also been leveraged if not directly, then through derivatives. Thus, what we have is the Fed trying to ensure price stability, while acknowledging that the economy is in shambles. The only outcome of such a scenario is currency debasement - if no currencies are able to become the world standard, then US foreign reserves will probably take the lead - gold. Mind you, I'm not a gold bug - I am in every way repulsed by the idea that we return to the gold standard. But, what other outcome is there?
On Jan 09 10:24 AM Crocodilian wrote:
The point about private debt collapsing is that the demand for public debt may not be "fast losing its market". At this moment, no one wants to hold anything much except Treasuries. The drop in demand for private debt instruments means that, unless people convert their capital into some other form -- which they're clearly not doing-- there will be a commensurate rise in demand for Public debt.
There's been no great flow into the Euro, the Yen, or the Yuan, no significant flow into US or any other equities, no flows into real estate. So basically there's a vast pool of money that doesn't want to invest anyplace, and is sitting in cash . . . which means they're in Treasuries.
If there were no buyers for public debt: Where does the money go? If you're holding cash in your brokerage account, you're holding Treasuries (indirectly). Seems to me that Treasuries can't fall until some other asset class begins to see a massive flow of money in . . . and that just isn't happening (yet).
On Jan 09 11:33 AM constructe wrote:
> Short term debt spending is a problem but much more parasitic is
> long term endemic spending. As the public sector becomes a greater
> and greater part of our economy even if the government can pay debt
> through taxes there is something seriously wrong if the public sector
> accounts for over 10% of GDP.
>
> Are we on our way to becoming like Russia,China, or India? Whenever
> we think the government spending is short term we always find out
> we are badly mistaken. Wasn't Iraq and Afghanistan suppose to be
> a sort term cost? Wasn't TARP suppose to solve everything. TARP like
> spending is looking to be here every year until 2012.
>
> According to doomsayers that's when the world ends lol...
"This may sound strange to you, but what you wrote here just proved my point, IMHO. Most people are not having cash sit in their brokerage account - they are de-leveraging by paying off as much debt as they can, and are thus increasing the savings rate in our country."
If they pay down their debt (which many are doing, and which is their best use of available funds, IMO) that reduces the aggregate demand for debt. That was my point.
Total debt= Public Debt + Private Debt
If private debt falls and public debt rises, the net borrowing requirements of the economy, taken as a whole, stay constant.
The key to the Fed's success is that foreign buyers of Treasuries continue to buy when they have little reason to do so (0 yields). If they continue, the Fed can stop worrying about inflation, and fight deflation until there's a recovery. However, who is to say that these foreign buyers are themselves healthy enough to prop up the US economy?
Good bait - I took your line about brokerage accounts hook line and sinker - your original point about brokerage accounts has nothing to do with anything.
The main question is that private debt is falling, and public debt is rising, but only due to foreign demand. Once that demand dries up, then you have private debt falling, and public debt falling as well. That has been my point all along, as well as the author's point. Thank you for disproving your distraction.
On Jan 09 12:04 PM Ricard wrote:
> @Croc:
>
> Good bait - I took your line about brokerage accounts hook line and
> sinker - your original point about brokerage accounts has nothing
> to do with anything.
Sure it does. If you sell stocks, and hold the proceeds uninvested in cash: that's demand for Treasuries. If you sell a money market fund, and hold the proceeds in cash, you have shifted from (say) GE commercial paper to a US Treasury (and the US Treasury is using the proceeds to fund that same GE commercial paper). Aggregate national debt is unchanged in such a transaction.
>
> The main question is that private debt is falling, and public debt
> is rising, but only due to foreign demand. Once that demand dries
> up, then you have private debt falling, and public debt falling as
> well. That has been my point all along, as well as the author's
> point. Thank you for disproving your distraction.
Not sure what "your distraction" means.
The increasing demand for public debt to a large extent is offsetting a fall in the demand for private debt. It is not clear that its "only foreign demand" for US Treasuries that are holding up the price.
The evidence, such as it is, is that a big chunk of the increased demand for Treasuries comes from US investors shifting out of other assets.
1) This article is about foreign demand for Treasuries dropping.
2) People are selling stocks to pay down other debts, not to hold Treasuries in their money market account.
3) The "distraction" is this entire side note about personal brokerage accounts, which is entirely irrelevant to this discussion.
4) If you have hard numbers to prove your point about domestic Treasury demand, I'm all ears - I am basing my argument on articles cited here as well as what I've read the past 6 months - no hard numbers outside of the Chinese currency reserve of nearly 2 trillion, most of which was built in a very short amount of time. If China, say, reduces demand for Treasuries by $300 billion, that will be $300 billion that will have to come from other sources. What other sources are there? Domestic demand? I find your argument to be suspect without some sort of basis for comparison.
Here's a link charting China's currency reserve growth. According to Wikipedia, it's at 1.9 trillion as of September.
www.caseyresearch.com/...
According to this article, these currency reserves grew 40% last year..meaning that a precipitous drop is quite a possibility.
chinaeconomywatch.blog...
Bottom line, I find there to be quite a basis for the arguments in this article, and for the point of view of a crisis developing without foreign aid. I find less credible basis for your arguments right now, although I certainly would be persuaded by some hard data.
"If they pay down their debt (which many are doing, and which is their best use of available funds, IMO) that reduces the aggregate demand for debt. That was my point.
Total debt= Public Debt + Private Debt"
Perhaps we are suffering from miscommunication. Your point about brokerage accounts was that people are selling private debt to stock up on public debt. However, your above quote is stating that people are selling private debt to lower aggregate debt, not to stock up on public debt. I hope you understand why I cannot follow your line of thinking.
> @Croc:
>
> 1) This article is about foreign demand for Treasuries dropping.
The article is about supply of Treasuries increasing. Hence the title: "More debt". It suggest that foreign demand for Treasuries may fall.
I point out that while foreign demand for Treasuries may be falling -- and that's not showing up in the dollar, merely a speculation of what might happen-- US demand for Treasuries is clearly increasing.
That point is clearly relevant to the author's assertion.
>
>
> 2) People are selling stocks to pay down other debts, not to hold
> Treasuries in their money market account.
The are doing both. If you sell stocks to pay down debts, you are reducing total indebtedness of the US (Public+Private), and increasing US savings rate-- which allows US domestic absorption of Treasuries to be higher. The more a nation saves, the more its government can borrow.
Much of the sales proceeds are not being directed to paying down debt, though-- brokerage cash levels are at extremely high levels. Those cash balances are increasingly invested in Treasuries.
So the point about cash balances in brokerage accounts is also relevant.
> 3) The "distraction" t... is this entire side note about personal
> brokerage accounts, which is entirely irrelevant to this discussion.
Increasing US demand for Treasuries is relevant to a discussion of problems of absorbing supply of Treasuries.
> 4) If you have hard numbers to prove your point about domestic Treasury demand, I'm all ears.
Take a look at Treasury auction results, massive covers at near-zero yields. Where do you think that demand is coming from? The article says China's not buying more.
For hard numbers on investor asset allocation, you can check the Investment Company Institute, for their monthly reports "Trends in Mutual Fund Investing" (covers mutual funds only-- brokerage numbers are more complex)
www.ici.org/stats/mf/a...
You'll note that in November, "Taxable Money Market Funds" is the only category recording an increase ($130 billion inflows). The increase for October was also around $130 billion. As commercial paper borrowing decreased dramatically in that period, much of that increase in money fund assets was demand for Treasuries (as you can see by looking at the holdings of your favorite taxable fund)
Here's Schwab's statement of why its closing its government money fund to new investors, which gives a good sense of what US individual investors are doing:
Q: why did Schwab decide to close the Schwab U.S. Treasury Money Fund to new accounts?
A: Due to the market-wide demand for U.S. Treasury securities, Treasury yields have dropped to record lows. As clients continue to move their assets to U.S. Treasury money market funds, portfolio managers must invest new assets in short-term Treasury securities that are currently at historically low yields.
That's fairly clear evidence that US investors' demand for Treasuries is large, and in fact so large that the current supply can't satisfy it. Look at the yields, or the extraordinary bid to cover ratios in recent auctions for confirmation of that.
On Jan 09 09:39 AM Michael66 wrote:
> People just do not comprehend how much harm they do to the American
> economy when they buy an imported car.
>
> Take, for example, the effect of buying a $50,000 Mercedes here in
> the US.
>
> Approximately 60% of the list price of the Mercedes or $30,000 is
> transferred to Germany. That is $30,000 of American capital. The
> US loses $30,000 of capital and Germany gains $30,000 of capital.
>
>
> This $30,000 of capital is permanently lost to us. We can no longer
> use it to invest in America.
>
> In addition to a transfer of capital, that $30,000 transferred to
> Germany also represents $150,000 of jobs transferred to Germany.
>
>
> Economists figure that when one dollar is introduced or transferred
> out of a country it actually represents $5.00 of jobs gained or lost.
> This is called the “Job Multiplier effect” of capital lost or gained.
>
>
> Multiply $30,000 by the standard job multiplier of 5 and you have
> the sum of $150,000 which is the dollar value of jobs that the $50,000
> Mercedes sent to Germany and that we here in the US have lost. <br/>
>
> In other words, the purchase of the Mercedes lost America the equivalent
> of three jobs each paying $50,000. Germany gained the equivalent
> of three jobs each paying $50,000.
>
> Currently we are transferring $6,000,000,000 (six billion dollars)
> of capital per day out of the US to purchase depreciating and wasting
> assets. In essence, we are squandering our capital.
>
> This is a disaster in the making.
Interesting. Your point is a guess, but a good guess. Seems our holdings in taxable money markets are about 3/2x China's foreign currency reserve, but those money markets would include all of that other crap, like commercial paper, that shouldn't have been there in the first place.
Thanks for your info. It's a little shocking that people are flocking to Treasuries given negative yields - I thought it was just foreign govts doing it for political reasons.
Perhaps a good compromise on what this article is getting at is
"The article is about supply of Treasuries increasing. Hence the title: "More debt". It suggest that foreign demand for Treasuries may fall. "
and
"This article is about foreign demand for Treasuries dropping." - "Less Filling"
Cheers :)
On Jan 09 01:00 PM Ricard wrote:
> Croc:
>
> "If they pay down their debt (which many are doing, and which is
> their best use of available funds, IMO) that reduces the aggregate
> demand for debt. That was my point.
> Total debt= Public Debt + Private Debt"
>
> Perhaps we are suffering from miscommunication. Your point about
> brokerage accounts was that people are selling private debt to stock
> up on public debt. However, your above quote is stating that people
> are selling private debt to lower aggregate debt, not to stock up
> on public debt. I hope you understand why I cannot follow your line
> of thinking.
>
Its not an either-or situation.
They are doing both: reducing debt and increasing direct and beneficial holdings of Government securities.
Consumer debt is falling. This is occurring both through paying down existing debt, and through a dramatic decline in the assumption of new indebtedness.
At the same time, investors are sitting on mountains of cash, investing it into the safest money funds that they can find. ($260 billion in inflows in October and November alone . . . I would imagine that December was similar). What do these funds do with this money? Buy various Government securities, largely. . .
Bear in mind that both these actions by US investors make funding the deficits easier. As investors pay down debt, the most credit-worthy private debt is removed from the market (if you can pay down your debt in this environment, you're in better shape than most); this increases the capacity for the economy to absorb more Government securities.
If they hold cash, that cash ends up (largely) invested in Government securities.
All this could change . . . but right now, the problem for the US is not finding people to buy Government paper -- its getting them to write a check for anything _other_ than Government paper.
experienceiseverything...