The Shell Game Continues...
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Monday, April 5, 2010
- Record-breaking Treasury auctions continue to go off without a hitch, thanks to massive foreign participation.
- However, the amounts reported to be bought in the auction results do not match the Custody Account or TIC report amounts.
- The Fed is allegedly all done buying MBS and Treasury paper. This cuts off an important source of liquidity for the Treasury, commodity, and stock markets.
- How will these markets respond to a liquidity drought?
The end of March is upon us. I need to take a moment to re-analyze the data to see what might happen now that the stimulus money has worn off, and, more importantly, now that the Federal Reserve's massive Mortgage Backed Security (MBS) purchase program is over.
This is important for a variety of reasons. The first is that the enormous flood of liquidity that the Federal Reserve injected into the financial system has found its way into the Treasury market, supporting government borrowing and also lowering interest rates for the housing market. How will the Treasury market respond once the liquidity spigot is turned off?
The second is that this flood of liquidity has supported all sorts of other asset markets along the way, including the stock and commodity markets. What will happen to these when the flood stops? Will the base economy have recovered enough that the financial markets can operate on their own? Will stocks falter after an amazing run? Or will the whole thing shudder to a halt for a double-dip recession?
Back in August of 2009, I wrote that the Federal Reserve was basically just directly monetizing US government debt by buying recent Treasury issuances as well as Mortgage Backed Securities (MBS).
Here's the conclusion from that report:
The Federal Reserve has effectively been monetizing far more US government debt than has openly been revealed, by cleverly enabling foreign central banks to swap their agency debt for Treasury debt. This is not a sign of strength and reveals a pattern of trading temporary relief for future difficulties.
This is very nearly the same path that Zimbabwe took, resulting in the complete abandonment of the Zimbabwe dollar as a unit of currency. The difference is in the complexity of the game being played, not the substance of the actions themselves.
When the full scope of this program is more widely recognized, ever more pressure will fall upon the dollar, as more and more private investors shun the dollar and all dollar-denominated instruments as stores of value and wealth. This will further burden the efforts of the various central banks around the world, as they endeavor to meet the vast borrowing desires of the US government.
My surprise at all of this has been twofold. The shell game has continued this long without the bond market calling the bluff, and I am baffled by the extent to which the other world central banks have both enabled and participated in this game
Part of the explanation behind this unwavering support for the dollar and US deficit spending by other central banks lays in the fact that other Western and Eastern governments are equally insolvent. It's possible that they feel they really have no choice but to play along, because the alternative would be to inflict a vicious and deeply unpopular austerity program on their own country, while everybody else is partying on thin-air money. Who's going to be the first to do that? Nobody, that's who.
The Size of the Problem (or is it Predicament?)
Let's begin by noting the massive growth in the Treasury auctions over the past few years. Where once we required a few hundred billion per year of new, incremental borrowing to fund the fiscal gaps, we are now borrowing more than a trillion each year. Where the total size of all auctions (including roll-overs) was a couple of trillion each year, it is now approaching ten trillion.
The way I prefer to track this is at the source. The media does an especially poor job of communicating accurate government deficit figures. They simply relate the cash deficit, which is how the government reports it. However, the true borrowing needs due to the deficit are best, and most easily, tracked by simply noting the increase in the "debt held by the public" portion of the federal debt. Why the press misses out on this year after year is beyond me.
We know that in 2009, the incremental borrowing needs of the federal government (give or take a few billion, due to timing) must have been equal to the reported growth in the "debt held by the public" portion of the federal debt.
That figure for 2009 was $1,491 billion (or $1.49 trillion):
Recall that the total federal debt consists of the two components in the table above; 'debt held by the public' and 'intragovernmental holdings.' The former represents the size of all outstanding Treasury debt, and the latter represents money that the government has borrowed from itself but owes to various retirees and entitlement beneficiaries.
When the value of 'intragovernmental holdings' rises, it means that cash was borrowed from the entitlement programs and used to fund government operations. If it rises, as we see above in 2009, then more money is coming in than going out. If it is stagnant, then money coming into the programs is being equaled by money leaving. If, heaven forbid, it falls, that means that the programs are now cash-flow negative to government coffers and more money is being paid out than is being taken in, which is our current situation here in 2010 (see next table below).
At any rate, for our purposes, we need to try and figure out where a record-shattering $1.49 trillion in fresh Treasury issuances went in 2009. Who bought them? How much went to foreign buyers, and can we expect them to buy more?
And so far in 2010, we see that we are on track for another ~$1.5 trillion round of fresh borrowing:
Taken together, this means that in only two short years, 2009 and 2010, as much new Treasury debt will be auctioned off to the public as was outstanding in 1995. Since government borrowing never gets paid down, at least in modern history, it means that the last two years have seen as much borrowing as happened over the period in which electricity was strung to every house, the highways were built, and our population tripled. What can we point to that was created over the last two years to rival those accomplishments?
Even more interestingly, we note something quite extraordinary in that table above: Through the middle of March, the intragovernmental holdings have not increased, which indicates that expenditures are equal to revenues for the entitlement programs. This has not happened for decades. It means that from a cash-flow standpoint, the US government has lost an important source of liquid operating cash. This is an enormous inflection point in the data series. Instead of providing cash to government operations, the entitlement programs are now on the verge of draining cash. The importance of this shift cannot be overstated.
Which brings us to the most important question of them all, which concerns the continued ability of the US and various other world governments to fund their deficits. It is my contention that too few people are thinking about the possibility that the US government could face a funding crisis at some point, which means that it's a clear and present danger.
US Treasury Auction Results
Let's look at the Treasury auction data since 2009 to see what it can tell us. To begin with, an auction may do a couple of things. It may sell brand-new debt to raise new cash, it may "roll over" past debt that is maturing, or both. So where 2009 saw $1.49 trillion in new debt sold, the total volume of the Treasury auctions was far larger, when we add up all the roll-over activity.
Here's the data for the total activity 2009 and some of 2010:
(Note: This data excludes TIPS and cash management bills, so these numbers are actually smaller than the complete total.)
The table above tells us that while $1.49 trillion in new debt was issued in 2009, more than $8.5 trillion in total activity took place. That's how much cash had to flow through the Treasury auction market for it to function.
This illustrates why a failed Treasury auction will be avoided at all costs. Any interruption to the trillions and trillions of dollars flowing through the Treasury market each year would cause an immediate and enormous train wreck that would ripple through the entire world's financial system (and trigger an avalanche comprised of hundreds of trillions of dollars of interest-rate derivatives). A failed auction is simply not an option for the Fed or the Treasury Dept.
In 2010, more than $1.5 trillion in total activity had already occurred by March 10th. Once we mentally add in this year's likely borrowing, we might expect a grand total of some $10 trillion in total activity to take place by the end of the year. In 2003, the total activity of this market was only some $3.4 trillion. If you plot out the growth in activity, it looks like an exponential chart.
With government deficits in the trillions stretching as far as the eye can see, and with an ever-increasing reliance on short-term debt, this trend is set to increase going forward.
Where It All Went
So now we know that nearly $1.5 trillion of new Treasury debt went out the door in 2009, along with another $371 billion in 2010. But where did it all go? Who bought it? Can we count on them to keep buying?
Here the data is not as clean and clear as I would like. There is quite a bit that is difficult to determine, based on the way that that data is collected and reported. While it may not be the intent of the data gatherers to hide anything, that is the result.
In terms of the disposition of the $1,491 billion in Treasury bonds bought in 2009, here's what we do know:
- The Fed bought $300 billion of them, all long-dated securities.
- According to the TIC report, foreigners bought $617.6 billion.
- The rest, 'the plug factor,' was assigned to "households" by the Federal Reserve, accounting for more than $530 billion.
There are many who have questioned whether "households" were in any position to park more than 100% of their entire personal savings into Treasury instruments, but even the Fed tells us that this is a plug category, meaning anything not identified as going to itself or foreigners is assigned to this category. The Fed has no idea how many Treasuries "households" bought in 2009; it only knows how many are not otherwise officially accounted for and that it should assign the difference to "households."
The truth is, we have no idea where that half-trillion in Treasuries went. My best guess would be that they mainly went to large banks (probably even the primary dealers themselves) to a large degree, especially those that sold MBS to the Fed. In keeping with the "shell game" concept, the only entities out there with a half-trillion lying around in 2009 probably got it from the Fed.
An asterisk in this story of where those Treasuries went concerns the difference between what the Treasury reports that foreigners bought (in the TIC report) and what the Fed says foreigners accumulated in the Custody Account. Unfortunately, these two reports overlap to a large degree, but not completely. This is a critical bit of investigation to perform, because it is so important that foreigners continue to buy US Treasury debt. In 2009, the Custody Account holdings of Treasuries increased by $572 billion, while the TIC report said foreigners bought $617.6 billion, and we are unable to account for the whopping $45 billion difference between the two numbers.
The Custody Account
I described the Custody Account in some detail back in August of 2009 in The Shell Game, so I won't rehash how it operates here, except to say that it is basically a gigantic brokerage account held by the Fed on behalf of foreign central banks.
In order to understand foreign buying habits when it comes to Treasuries, we need to peer into both the TIC and the Custody Account. When we did this last August, here is what we found for the Custody Account:
The story in August of 2009 was one of rapid, uninterrupted growth in the Custody Account, seemingly without any concern or regard for the financial crisis happening then.
Today we find that during 2010, the Custody Account has not grown very robustly:
I am immediately drawn to the fact that the foreign Custody Account has been, well, a little flat lately (as marked at the end by the blue line at the top right). However, it's also been a little flat at other times, which I have marked with dark horizontal lines, so perhaps this is a relatively normal occurrence. Overall, perhaps we should be most impressed with the >250% growth over the past seven years(!).
Think of this $3 trillion debt as the portion of US government debt that is owed to a foreign credit-card firm. Someday that's going to have to be paid back, and, no, it doesn't bode well for the future prosperity of the US.
Here's the Custody Account in table form, which reveals that 2010 is shaping up to be the weakest year in a long time:
I'm sorry, but a 5% growth in the Custody Account just isn't going to cut it for a country with a multi-trillion-dollar borrowing habit. So far, the Custody Account has only increased by a paltry $26.5 billion in 2010. That's a real cause for concern, and it makes me wonder about the recent upward volatility in Treasury yields.
Now, the Custody Account consists of both Treasuries and Agency debt. Teasing this apart into its components, we find that total Treasury accumulation into the Custody Account has been a quite anemic $24.6 billion in 2010, which is more or less the same amount that was accumulated during a single week back in 2008 and 2009.
Let's compare this $24.6 billion to the $371 billion of new Treasury debt sold in 2010 - it's only 7% of the total. But we are told, week after week, that foreigners (via the "indirect bid") have bought on the order of 40% of each auction, or nearly $150 billion. What gives?
Like here in this recent auction, where 39% of a single auction totaling $16.6 billion went to the indirect bidders:
What we are seeing here is a very large (and growing) disconnect, between the proportion of Treasuries that are said to be bought by foreigners in the Treasury auction result announcements, and what's showing up in their official TIC and Custody Accounts.
I am increasingly concerned that this gap reflects a growing accumulation of Treasury issues by entities funded for this purpose by the Fed's magic thin-air checkbook. If so, then the danger would be the response of the market and the reaction of various countries when that becomes common knowledge.
For now, it is clear that 40% of US Treasury auctions are not being bought by foreigners, at least if the TIC and Custody Account reports are to be believed.
Perhaps the growth in the Custody Account will resume and my concerns will amount to nothing, but the first quarter of 2010 is shaping up to be somewhat of a gigantic disappointment in that department. Unfortunately, the TIC report is lagged by a couple of months, so we won't have the March numbers for comparison until the middle of June. My guess is that the TIC report will also show weakness in the foreign accumulation of Treasury debt, but we'll also be taking a look then, just to be sure.
The concern here is that the Custody Account is reflecting early signs of waning foreign interest in US debt. If (or when) we finally reach the point of saturation in this story, everything will change rather dramatically.
From Zero Hedge, we have this nice summary of the debt auctions coming up for next week:
The Treasury just announced the auction schedule for next week: a total of $165 Billion in gross issuance of which $74 Billion in coupons, and $8 billion in a 10 Year TIPS reopening.
- $28 billion in 3 Month Bills, Auction date April 5
- $29 billion in 6 Month Bills, Auction date April 5
- $26 billion in 52 Week Bills, Auction date April 6
- $40 billion in 3 Year Bonds, Auction date April 6
- $21 billion in 9 Year 10 Month (reopening), Auction date April 7
- $13 billion in 29 Year 10 Month (reopening), Auction date April 8
- $8 billion in 9 Year 9 Month TIPS (Reopening), Auction date April 5
The fact of the matter is, the US government is now conducting weekly Treasury auctions that are as large as quarterly auctions were just a few years ago. Exponential increase, anyone? $165 billion in a single week is an enormous pile to unload.
What I Am Always Looking Out For
Long-time readers know that I am constantly on the lookout for a specific pair of market signals above all others, because its arrival will signal that a new game has begun. That pair comprises a simultaneously falling US dollar index and rising Treasury interest rates (signaling falling Treasury bond prices).
In essence, this pair will signal to me that some major player, perhaps China, has decided to sell its Treasuries and take its money home, thereby driving down the dollar. This is critical to me, because it will mean that the US will have begun its long date with funding difficulties. Either interest rates will have to rise dramatically to attract new lenders (thereby killing the nascent recovery of the housing market and our entire credit-fueled economy), or the Fed will have to begin monetizing at an even faster rate than before.
In short, we'll be facing a period of profound austerity, raging inflation brought about by currency devaluation, or both. In truth, I cannot imagine any possible way for the US to pay off its current official debts in current dollars, so I feel this outcome is merely a matter of time. However, it could be a long time, and we must also be prepared for that.
In the past week, there was a bit of excitement over in the Treasury market because there were two days of hard selling in a row. This led to Treasury yields spiking and possibly breaking out over a two-year trend line:
The Treasury market immediately settled down right after these two days of selling, but something significant had clearly happened. During this period, the dollar also rose quite handily, so my "signal pair" was not in play and I did not issue an alert, nor did I become overly concerned. However, I did sit up and take notice and am following bond market signals with just a bit more focus these days.
A rapid rise in long-term interest rates here would be just about the last thing the Fed would want, as that would put pressure on stocks and commodities, and harm the housing recovery, such as it is. So I doubt that the rate rise was planned or welcomed.
I am keeping a very close eye on the Treasury market right now and will alert you if anything breaks suddenly or crosses the threshold to actionable news.
One Possible Scenario
Although I am not convinced that I have access to good data, it would seem that China is in a serious bubble. Or, rather, a series of bubbles, including real estate in several metropolitan locations and manufacturing overcapacity. Several recent commentators have been adding up the facts as we know them, and it seems plausible to suspect that China is deep into bubble territory.
China also happens to hold $890 billion of US Treasuries (as of January 2010), as well as some amount of MBS stashed in the Fed's Custody Account (I don't have access to the necessary detail to say how much), so we'd be close if we estimated that China held $1 trillion of official US debt.
One scenario that I think has a chance of upsetting things would be for China to experience a bubble-bursting crisis, the mitigation of which would necessitate a need for liquid cash. By this, I mean an event (or set of events) that would essentially force China to begin unloading their Treasury holdings.
Under this scenario, we'd see immediate selling pressure in the Treasury market, leading to lower prices and higher yields. I think this event would be sufficient to rip the cover off the Treasury market and expose the extent to which the market has been supported by central banks more than legitimate market players and expectations.
So another thing I am keeping an eye out for is any sign that China is experiencing a bubble-bursting event. Here I track the Chinese stock market, the Baltic Dry Index (as a crude measure of export activity), and the news.
With a stagnant Custody Account reading and underwhelming TIC reports, it seems unlikely that that foreigners are going to be able to digest the volume of Treasury auctions that are coming up this year. We've already seen a nice breakout on yields. With everything I know about Fed policy at this point, I can assure you that a sudden jump in rates on the long end was not in the Fed's plans for last week.
My concern is that the mysterious indirect and direct buyers that have been showing up at Treasury auctions lately may be none other than the Fed itself or its proxies, hidden by some slight shell game or another.
There simply seems to be no other explanation, given the perilous state of the global economy. Where is all this capital coming from, if not central banks? From earnings? From exports? From legitimate economic savings? From private individuals (during a major stock bull run)? None of these explanations matches the volume of borrowing that we are seeing in the US Treasury market, let alone worldwide.
The simplest explanation is that central banks are somehow providing the necessary liquidity to support the various governmental bond auctions that are happening around the world. The US story does not add up and provides enough of a smoking gun to suggest that there are (at the very least) non-transparent buyers for the massive, record-breaking Treasury issuances we've been seeing lately.
If, or when, these deceptions are revealed, I predict that we will experience a pretty significant market dislocation that will take the form of a chaotic bond market, with yields that rapidly gyrate higher, currency perturbations that will shake markets, and an extended banking holiday, with capital controls imposed until a nightmarish derivative mess is unsorted.
Of course, these are just my hunches at this point. Something is very much 'not right' in this story, but over the years I have learned that strange market conditions can last longer than you think possible and that things always seem to unfold more slowly than you might initially suspect.
So I am prepared for two possible scenarios: 1) a sudden change in the markets, and the alternative, 2) no change at all for ten years or more. The first requires active financial and physical planning, while the second requires developing the right sort of mental patience. It is a tricky psychological balancing act, to be ready for anything and nothing at the same time. I imagine that being on patrol in Baghdad during hostilities was sort of like this, where nothing happened for 99% of the time, but then IEDs made the other 1% of the time very, very interesting.
What will happen next? Nobody knows. My advice remains the same as always: Stay tuned to the world's markets and happenings for clues about what's unfolding, but make the necessary preparations to increase your resilience to whatever might happen next.
The current market environment , where everyone is seemingly convinced that a recovery is now all but assured, is both encouraging and concerning. Encouraging because that's most likely true. Concerning because sharp breaks almost always happen during periods of complacency, when everybody seems to be looking the other way. In short, when everyone is complacent, I get concerned, and when people get concerned, I try to remain calm.
For now, there's a level of complacency about Treasury auctions that I find very disturbing. There's really no way to make the story add up properly - I mean, how could it, with $1.5 trillion in new borrowing for two years in a row during economic weakness? - yet almost nobody seems to be concerned about the implications of that line of thinking.
That is exactly the territory where great fortunes are made and lost. At the very least, my wish is for you to preserve what you have and to be able to maintain an even keel and positive outlook, no matter what the future brings.
For myself, this means putting in 25 fruit and nut trees on my property (accomplished this past weekend), followed by expanding the garden and installing solar and energy efficiency improvements. We shall see if these turn out to be good uses for my capital and time. For now, they provide me with the psychological sense of forward movement and improvement, both of which are very important to me right now and worth every penny to me all on their own.
Your faithful information scout,