Thursday, March 18, 2010

The Trouble With Bonds

by Charles Hugh Smith

The U.S. deficit and the Treasury bonds which must be sold to fund it are beyond comprehension--but I try anyway.

The trouble with bonds (the U.S. Treasury variety, among others) is simple: there's too stinking many of them being issued. Given that every government on the planet except Lower Slobovia is issuing unprecedented quantities of debt (bonds) to fund their skyrocketing deficits (and Lower Slobovia would too, if its credit rating wasn't -ZZZZZ), then we have to wonder who will be showing up to buy the $1.6 trillion in freshly printed T-bills the U.S. Treasury will issue this year to cover the expected Federal deficit.

This is of course "the new normal" given last year's $1.4 trillion deficit.

So what does that number--$1.6 trillion in newly issued Treasury bonds to fund this year's deficit--mean in the real world? We might start by asking who is going to buy that stupendous issuance of new debt.

Just to put that $1.6 trillion into some sort of context, let's add up all the Treasury debt currently owned by the two largest foreign holders: China and Japan. According to the most recent statistics issued by the Treasury, China holds $889 billion and Japan holds $765 billion.

Together the two nations own $1.65 trillion in U.S. T-bills of varying maturity. Interestingly, both nations have been trimming their holdings of U.S. debt recently.

So to fund the current $1.6 trillion deficit, both China and Japan would have to double their holdings in just one year. (Perhaps they could use the $ .05 Trillion difference--$1.65T minus $1.6T--to visit Disneyland and Disneyworld.)

Since the two largest holders of debt are selling, not buying, hoping they will double their stakes this year is asking a bit much.

And then there is the 2011 deficit to sell, too, and we can't expect China and Japan to pony up another $1.5 trillion for next fiscal year's staggering deficit.

How about domestic demand for bonds? Aren't we hearing pundits declare that Americans can easily support their own government's deficits? Talk is cheap, especially for the punditry. According to BusinessWeek/Bloomberg, U.S. investors dumped $369 billion into bond mutual funds since March of 2009, while they extracted $26 billion from equity/stock funds.

That $369 billion went into a variety of public and private bonds, including local government municipal bonds and corporate bonds, so by no means did all of it go into T-bills.

But even if every cent had been used to purchase new Treasury debt, that $369 billion would have bought a mere 23% of the $1.6 trillion of new T-bills being issued this fiscal year to fund the deficit.

How about all those savings Americans are now socking away? Couldn't we fund that $1.6 trillion a year out of savings?

Well, no. According to the BEA (Bureau of Economic Analaysis), the savings rate is 3.3%. A spike in the savings rate to 6.9% was reported in mid-2009 by the Commerce Department, but it seems that was inflated by stimulus checks distributed by the Federal government.

Feel free to argue the point with the BEA. Elsewhere they put it at 4.3%. Since total personal income is $12 trillion, then that means the total savings generated each year is on the order of $400 to $470 billion.

So taking the higher estimate ($470 billion), if every cent of savings stashed away by all 130 million American households was put into Treasury bonds, that would only come to 29% of the deficit.

It seems American investors aren't buying many T-bills. 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 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)?

Another source of buying is--once again--China, based on the idea that since China runs a huge trade deficit with the U.S., it has to park all those dollars somewhere. True, but the trade deficit with China has shrunk to around $190 billion a year, so even if Beijing parked its entire surplus in T-bills, that would only soak up 12% of the $1.6 trillion.

There is simply no evidence that any pool of buyers exists outside of the Federal Reserve to soak up $1.6 trillion in newly issued Treasury debt this year. Yes, the Fed can "create" money and use it to buy Treasury debt via various third parties, but is that machinery up to buying endless trillions of dollars in new bonds to fund unprecedented deficits as far as the eye can see? Will there never be any consequence of that policy, or any limits imposed by the bond market?

The only proven way to attract buyers is to raise the yield on bonds. But we all know what will happen to interest-rate-sensitive assets like existing long-term bonds, stocks and real estate when rates rise: they will drop.

There is no free lunch, and the idea that the U.S. can sell endles trillions of new debt without consequence is an illusion.

I addressed some of these same issues in Why Interest Rates Will Rise in 2010 (December 24, 2009)




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