Interest rates, artifically suppressed by the Federal Reserve and China, are about to start rising, and will continue rising for a generation.
On Christmas Eve 2009, I wish I could parrot the "happy-happy" Party Line that interest rates and mortgage rates will stay low for essentially ever, but that would require lying. The truth is the drivers of super-low interest rates are diminishing, and the forces of higher rates can no longer be restrained.
There have two primary drivers of super-low interest rates: The Federal Reserve and the Chinese buying Treasury bonds.
The Fed has created massive artificial demand for more U.S. debt in two ways; by direct purchase of bonds being auctioned (During the first 2 months of the new fiscal year, the Federal Reserve grew its balance sheet by about $65 billion, in effect purchasing about 22% of the federal government’s new debt) and by secretly buying Treasury bonds from "primary dealers" (banks) a few days after the auction.
This way, it appears for propaganda purposes that some private parties are actually buying T-bills to hold, when in fact they are only temporary proxies for cloaked Fed purchases.
The entire "package" of Fed buying of Treasury debt to keep interest rates low runs in the hundreds of billions--The Fed’s balance sheet ballooned to $2.24 trillion in assets as of last week, up 142 percent from the beginning of 2008. The Fed purchased outright $300 billion of longer-term Treasury securities, $1.2 trillion toxic-garbage mortgage backed securities no sane investor would touch, and hundreds of billions more in Treasury debt via proxy buyers.
And now as the Fed ends some of its lavish support of the Treasury debt, Congress and the Obama Administration are stepping up their borrowing to unprecedented levels:
So just as the Fed cuts back its purchases of massive new Federal debt, the Federal government is borrowing more? And who, pray tell, will be the "buyer of last resort" as the Fed trims its buying?
Not the Chinese Central Government: China's Dumping Of The Dollar Has Begun.
Here is the key dynamic to China's purchases of Treasury debt: when China's trade surplus with the U.S. was expanding into the hundreds of billions every year, the Chinese needed a place to park all those dollars. U.S. Treasury bonds were liquid, supposedly safe and available in limitless quantities.
Keeping interest rates cheap for their American "consumer" debt junkies made good sense as well. Niall Ferguson: How China's Insane Fiscal Policies Pumped Up Chimerica And Crushed America.
But now the gargantuan trade surpluses are shrinking, and the torrent of dollars has diminished. Standard-issue financial pundits (SIFPs) have been cheering the declining U.S. trade deficit, but they should be careful what they wish for: once the U.S. is no longer running a huge trade deficit, then all those exporter nations will no longer have hundreds of billions of dollars floating around, looking for a home in Treasury bonds.
According to China's General Administration of Customs, China's exports from January through October dropped by 20.5 percent compared with the same period last year. During the same period, its export volume to the US dropped by 11.3 percent, while the export price declined by 5.3 percent.
China-US trade volume decreased by 15 percent, according to Chinese customs.
China's trade surplus with the U.S. was US$24 billion in October, compared with $13 billion in September, bringing the total for the year so far to $159.23 billion.
Bilateral trade with the U.S., China's second-biggest trading partner in the period, is down 14.8% in the first 10 months this year, to $239.36 billion. Two-way trade with close neighbor Japan, China's third-largest trading partner, has crashed 19.3% in the period, to $182.34 billion. Business with the European Union, China's biggest trading partner, has suffered almost as badly, declining 18.7% in value to $292.42 billion.
China holds about $2.27 trillion in foreign reserves, about two-thirds of it in US dollars, up 19% from a year earlier. The country held Treasury bills worth about $797.1 billion in August, making China the world's largest holder of US Treasuries outside the United States, according to the US Treasury Department.
Here are the official U.S. trade statistics with China: Trade with China
Trade deficit 2007: -258.5 billion
Trade deficit 2008: -268.0 billion
Trade deficit 2009: -188.5 billion (est.)
In addition to having fewer dollars to park in T-bills, China has (as noted above) started trimming their holdings of long-term Treasury debt.
OK, let's add this up: the two primary sources of demand for new Treasury debt are scaling back or even dumping their holdings, while supply of new Treasury debt is increasing at record levels.
According to the laws of supply (increasing rapidly) and demand (falling), the Treasury's ability to palm off hundreds of billions in new debt every few months is about to outstrip demand by a long shot.
The only way to increase demand will be to raise interest rates, which will then spread to all layers of the economy. All interest rates will rise, including mortgages.
There really is no escape from this conclusion. And this isn't just about 2010--it's about 2010 through 2035, as bond rate cycles tend to run between 18 and 26 years. Just as interest rates fell for 26 years, now they will rise for a generation or so.
Short-term Treasury yields fell to near-zero in the global financial meltdown, but the basic idea of this chart remains valid: interest rates fell as Chinese ownership of U.S. debt skyrocketed. Once that ownership starts falling (along with Fed purchases), interest rates have nowhere to go but up for decades to come.
click to enlarge
For those who think the newly frugal American household or corporation will step up and buy the $1.4 trillion in new debt and the $2 trillion in debt being rolled over each and every year--dream on. According to Niall Ferguson in An Empire at Risk:
Unfortunately for this argument, the evidence to support it is lacking. American households were, in fact, net sellers of Treasuries in the second quarter of 2009, and on a massive scale. Purchases by mutual funds were modest ($142 billion), while purchases by pension funds and insurance companies were trivial ($12 billion and $10 billion, respectively). The key, therefore, becomes the banks. Currently, according to the Bridgewater hedge fund, U.S. banks' asset allocation to government bonds is about 13 percent, which is relatively low by historical standards. If they raised that proportion back to where it was in the early 1990s, it's conceivable they could absorb "about $250 billion a year of government bond purchases." But that's a big "if." Data for October showed commercial banks selling Treasuries.
That just leaves two potential buyers: the Federal Reserve, which bought the bulk of Treasuries issued in the second quarter; and foreigners, who bought $380 billion. Morgan Stanley's analysts have crunched the numbers and concluded that, in the year ending June 2010, there could be a shortfall in demand on the order of $598 billion—about a third of projected new issuance.
Of course, our friends in Beijing could ride to the rescue by increasing their already vast holdings of U.S. government debt. For the past five years or so, they have been amassing dollar--denominated international reserves in a wholly unprecedented way, mainly as a result of their interventions to prevent the Chinese currency from appreciating against the dollar.
At the peak of this process of reserve accumulation, back in 2007, it was absorbing as much as 75 percent of monthly Treasury issuance.
Our excellent confrere Jesse at Jesse's Cafe Americain addresses the same question with different sources and insights, but arrives at the same conclusion: Who is Buying All these US Treasuries (and can they keep it up in 2010)?
So if the Fed and Chinese cut back, due to not having more dollars to squander on T-bills or from various other constraints, then the pressure to sell Treasuries at whatever the market demands could cause rates to explode higher, to the surprise of virtually all observers.
Except Jesse and us, of course. We will only be surprised if they can keep the game going much longer.
I wish you all a safe and Happy Holiday -- my next post will be on 12/28/09.