Bernanke's Real Problem - Owners Of The U.S. Debt

by: Daniel R Moore

I have listened to a lot of different perspectives trying to explain what Ben Bernanke said or didn't say on Wednesday that has caused Treasury interest rates to spike above 2.4% on Thursday (6/20/2013) into a range it has not traded since August 2011, and the DOW (NYSEARCA:DIA) to have its biggest one-day point drop since November 2011. I don't know many investors who have not said that this move down in the stock market is unexpected. But I also have not heard many give a real root cause for the movement up in interest rates. Most are relational explanations describing what is taking place, such as the sell-off in the emerging markets. This is like telling me someone is going to be tackled in a football game. I cannot remember one time in financial history that emerging markets didn't get roiled when both the long-term U.S. interest rate market and the stock market sold off.

What I have been watching as this made for TV movie has been unfolding is what I believe is the root cause for the problem - the U.S. debt. More specifically, it is the holders of the U.S. debt, and their primary motivation for holding the debt. Most everyone that is as smart as a fifth grader knows that the Federal Debt is a very large number - $16.7T as of my latest data download for May. It actually went down in the past month from $16.8T in April - hurray. (Source:

You read the last sentence correctly - the U.S. total debt fell in the month of May. And the headlines are correct - interest rates are up, gold is down, emerging markets are roiled and the U.S. stock market (DIA) got hammered with a 353 point drop. The debt improvement should be great news. Not. Show improvement in the U.S. financial balance sheet in the slightest way and asset markets in general go into decline. Drive the country toward bankruptcy; get a credit downgrade from the rating agency - interest rates down, stocks up. What a country.

In this perverse financial market universe, I offer up one chart that I follow as the root cause:

(Source: Compilation of Data from St Louis Federal Reserve: FRED )

The chart follows the ownership of U.S. publicly traded U.S. Treasury securities. The public ownership figures include the Federal Reserve holdings because technically the Fed is a private bank, not a central bank. The chart excludes the intra-government holdings of U.S Treasuries, which are primarily social security and other government trusts, which are mandated to hold U.S. Treasury debt. These securities are not traded - so it in essence they do not affect the traded interest rate price on the margin for Treasury notes and bonds.

As the chart shows, the biggest percentage owners of U.S. publicly traded debt are foreigners, not U.S. citizens. The Federal Reserve makes up a growing percentage of the ownership lately as well, 15.6% in April. Although not shown on the chart because I do not have the foreign ownership data for May yet, the Fed increased its ownership in May to 15.8%.

So to sum up what is going on: the total U.S. debt outstanding is slightly shrinking, the Fed is increasing its ownership level through continued purchases (Fed Treasury purchases Jan-May averaged $35B per month), and interest rates, which the U.S. Treasury now has to pay on long-term debt is going up?

What is the Trigger for Higher Treasury Interest Rates?

What has happened to trigger the exodus out of U.S. debt now? Did some large holder named Rip Van Winkle suddenly wake up and decide that interest rates were suddenly too low just as the U.S. put itself in a better position to get control of the debt (maybe a bit tough in cheek, but on the margin it is true). Odd that rates should go up now just as the U.S. is improving its balance sheet - but maybe it is not if it is viewed from the perspective of the foreign owners of the debt. Many of these owners have not held the debt for the purpose of getting an interest return. Many of the foreigners hold the debt as "reserves," the purpose for which they may have official proclamations. But the reality for many of the holders is that since the early 1990s, when the "New World Order" began to be pushed as U.S. policy, the increase in U.S. debt has been an indirect proxy for U.S. consumption of foreign trade. Much of the USD currency driven from the trade found its way back into the U.S. monetary system as investment into government debt, which through fiscal policy has been re-distributed to create more consumption.

And now, beginning in May 2013, for the first time in a long time (Year 2000) the whole paradigm has been put into reverse. And it doesn't appear that it has been put into reverse by accident. In fact, on May 10, Jack Lew made headlines by warning Japan that it "must respect FX rules as it seeks growth." If you review the ownership of U.S. Treasury chart, and then combine it with the U.S. Treasury official statements in the press, you would have to conclude that they don't have any control over the country's exchange rate and monetary policy when foreign ownership of its traded debt is approaching 50% - otherwise, why would this statement even need to be made.

Up to the point in time this statement was released, the process of Fed QE purchases to keep Treasury rates low was working just fine. The possibility of Fed tapering is not the reason the markets are currently roiled - it is an excuse to explain what is going on in the market. It is the new focus on solving the structure and control of the U.S. debt that is the issue. The focus of the G-7 conference in May was (G7 Summit Looks to Bolster Recovery - May 10) was on creating greater domestic consumption by export driven countries. At the same time, the U.S. has turned its fiscal policy inward. Domestic energy production for instance, is one of the few real growth sectors currently.

This change, if it truly continues, is going to produce some major consequences - many of which are truly not understood at this point in time. But the first consequence may just be the start of a game of who can withstand the pain the most - the net exporting countries or the U.S. My recent articl,e which reviewed the changes in Japan's net investment holdings over the past year (Busted Yen Carry Trade - Time for Stock Investors to Pay Attention ) leading up to and after the announcement of Abenomics is very telling. It shows a country that was continuing on the old paradigm of exporting investment in support of its current account trade surplus position through the end of the 2012. During 2013, however, it has been attracting investment, and selling foreign investments, including U.S. Treasuries. This is a major change.

Game Changer or a Negotiation Position?

At least for the moment, the game has changed. Is it a negotiating maneuver to force the U.S. to force a run on U.S. Treasuries so that the interest rates rise so quickly that the U.S. has to respond with fiscal stimulus? Or, is it just a painful consequence of what is inevitable for the U.S. to get its government under control? - Probably a little of both. I do look for this to become a very interesting political football going forward as Ben Bernanke's replacement is selected and confirmed, right on through the 2014 mid-term elections. This will be a drawn out process, and like it or not, the foreign ownership of the U.S. debt will exert itself in the election process to have some level of influence on the outcome. The weapon of choice to exert that influence at the present time appears to be selling U.S. Treasuries and forcing a higher interest rate on the U.S. government. The motive, if there is one, or maybe it is just pure economics at work, is to maintain the U.S. market as the worldwide consumer of the emerging worlds "stuff." The addiction is something that may not be easily undone.

Ben Bernanke's Migraine

The real headache for the Fed chairman is that the consequences of changing U.S. and worldwide economic policies will be directly reflected in the motivations of the holders of U.S. Treasury securities. Clearly the Federal Reserve is not in control of the direction of interest rates at this point - with the exception of the very short end of the curve. If they did, their purchase program would easily trump the sell-off. However, the near majority holders of the U.S. debt by foreigners give a high degree of control over rates to other countries in the world. As long as they remain net-sellers of U.S. Treasuries, rates will go up.

Historical Market Analog: 1999 to 2001

There is a point in time that can be studied in recent history where there was an exodus of foreign owners from U.S. Treasuries. The time period was June 1999 to August 2001. During that time period as you can see on the chart foreign ownership of Treasuries declined from 34.9% ownership or $1.3T to 29.7% ownership or $.989T.

An equivalent reduction in ownership today would be a sell-off of roughly $1.5T, much higher if the holders were to return to year 2000 ownership levels. I probably don't need to remind readers of this article what happened over that time period. Is it a coincidence that the during that time period the U.S. actually ran a surplus government budget for the first time since 1962? The stock market ran up to a peak of over 1500 in August '00, and then went into a bear market decline to the 1100 range, a fall of 27%. Interest rates initially increased about 150 basis points on the 10 year as the market peaked, and then gradually declined. But at that time rates were already in the 6% range on the 10-year and 30-year bond, not 2.4% and 3.5% respectively. The fiscal cure eventually put in place was a tax cut, the Bush tax cuts. This seemed to satisfy the appetite of the export countries, which then resumed investment in the U.S. deficit spending through Treasuries purchases.

Investment Strategy in this Scenario

Now that the trigger has been pulled and the momentum is upward for U.S. Treasury interest rates, I do not see the process suddenly reversing course. This game is likely to be played for at least the next 18 months to 2 years. If this is the financial game that is being played, then it might be a good idea to prepare your portfolio for the likely outcome.

Stocks: The U.S. Equity markets are going to peak, and then fall until there is some expected fiscal resolution that is put into place. My opinion is that the 1672 peak reached on the S&P was likely the upper end of any range reached for some time. But there are still plenty of bulls who are sure that the push out of bonds (NYSEARCA:TLT) (NYSEARCA:TLH) (LAG) into stocks has not fully played out yet, and they are probably right. But even if a stock rally recurs (NASDAQ:QQQ), it will be short-lived if the pressure on rates upward continues. My advice is to play the equity part of your portfolio with some form of put protection because the market will be volatile and choppy. The real decline in equities will not begin until rates have peaked. With the level of foreign ownership positions that can be sold, and even the possibility of U.S. retirement funds and mutual funds hoping into the fray after the review of upcoming statements, rates in my opinion can easily rise much further and faster than most analysts are forecasting. Instead of buying dips, it is time to begin raising cash from riskier equity positions in stock rallies.

Bonds: Don't rush out and sell any established controlled duration bond positions (this is consistent with my recommendations throughout this year). Hopefully you plan to hold these positions to maturity, and history has been that rates will eventually reverse. When they do, there are likely to be many trading opportunities into better relative positions. And, over the interim, the duration of your holdings will shorten.

What I continue to recommend is to reduce exposure to constant long-duration mutual funds and leveraged bond funds. Do not make the mistake of holding an over-leveraged asset that is, or is about to, decline in value. If you raise cash and need to re-deploy, I suggest making sure you do not invest right now in any 5-year or longer maturity at a rate below 5-6% (4% for Muni's, and stick with insured offerings). If you are a longer-term investor, I am beginning to see swap opportunities into unleveraged longer-term bonds that are in the 6-7% range. I use this rate level as a target because it is actually better than what the stock market has been able to return since the year 2000 and it is higher than the constant dollar GDP since that time period as well. I do not expect that the stock market will be able to beat this return unless there is out-of-control inflation over the next 20 years. I am only recommending the strategy, not the actual issues, but here are some company issues I reviewed today which fit this profile: (AFW) (MET.B) (PRE.D) for traded debt and preferred stocks; issued bonds, which have declined over 20% recently in the emerging market natural resource sector being priced more attractively including Petrobras and Vale debt issues. All of these issues have high investment grade ratings.

Gold and Oil Investments: There are predictions that the current path for the U.S. is a severe bout of deflation. The facts in the economic statistics certainly show CPI lead inflation is not an issue. This is unlikely to change in the coming months without some combination of fiscal stimulus plus a major move upward in energy price levels. This is the combination of elements over the past 50 years that has created inflation in the U.S.

Gold is currently signaling the level that I expect the S&P500 will eventually drop to. Gold and the S&P traded up in correlated fashion since 2009, and I expect the two assets will unwind in value together. Gold however, is a leading indicator that should bottom ahead of any drop in stocks that may be caused by an extended drive upward in interest rates.

In the energy sector, I personally remain long the group because of the unknown about where U.S. fiscal policy is headed longer term. If government spending is unleashed with a newly nominated dove Fed chairperson, 3 years from now the landscape may be completely different. I currently invest in the sector using MLPs - (NYSE:PNG) is one name I currently like because it is not highly leveraged and has steady long-term cash flow contracts in place. I also invest in U.S. Royalty Trusts in order to get shorter duration through names like (NYSE:PER) and (NYSE:SDR). I also like the higher dividend names with upside like (NYSE:BP).

Disclosure: I am long BP, SDR, PNG, PER. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.