When Will The Bond Auctions Begin To Fail?

9 posts / 0 new
Last post
JAG's picture
Status: Diamond Member (Offline)
Joined: Oct 26 2008
Posts: 2492
When Will The Bond Auctions Begin To Fail?

Another intriguing, if not confusing, article from the Pragmatic Capitalist blog. I'm not sure I understand it, but I will post it here just to give Davos a headache, LOL....Jeff



When Will The Bond Auctions Begin To Fail?

22 JUNE 2010 BY TPC

There’s great concern over the sustainability of US deficits. Most of the fear mongering, hyperventilating, flat earth economists believe foreigners will at some point stop “funding” our spending. The hyperinflationist crowd likes to keep a very close eye on US government bond auctions hoping foreign demand for debt will dry up, auctions will begin to fail and interest rates (and inflationary pressures) will surge as the United States effectively defaults (which is technically impossible) and dies the death that so many of these people wish upon it.

Unfortunately, 99% of the inflationistas have a very poor understanding of reserve accounting so their arguments have not only been wrong for a very long time, but they never really carried any weight to begin with (as one reader eloquently put it – “at some point being right has to count for something” – the inflationistas have been horribly wrong throughout this downturn).  So what is really happening when the government auctions off bonds?  Let’s take a look.

First of all, we must remember that the US government bond market “funds” nothing.  As a sovereign issuer of currency in a non-convertible floating exchange rate system the US government never really has nor doesn’t have money.  For simplicity, the US government is much like an alchemist who simply presses a button (the government literally presses a button)  and abracadabra, they have money!  Inflationistas call this “money printing”, but in reality the government issues money that primarily offsets the dollars they debit from the private sector via taxation (in addition to a few other factors such as population growth, etc).

Second, we must remember that private sector net savings is public sector deficit.  TO THE  PENNY.  This is simply an accounting identity.  To grasp this relatively simple yet unaccepted concept, imagine if the US government imposed a one time 100% asset tax on it citizens.  What would happen?  The public sector would have all the assets!  The private sector would have nothing.  So it’s important to remember that taxation debits the private sector and deficit spending credits the private sector.  But what happens to that money when the private sector “gets” it?  They deposit it at a bank or it is electronically deposited.  What does this do?  This creates excess reserves at the banks.  So government deficit results in excess reserves.  By definition.

What happens next is where the fear mongering flat earth economists get it all wrong.  They think the Fed issues bonds to fund spending, but the US government is never revenue constrained.  The government doesn’t get a gold coin when they auction bonds just like they don’t care whether you pay your taxes in cash.  In fact, if you did pay your taxes in cash the IRS would send the pile of money up to the Treasury and guess what they would do?  They would shred it, or, if it was pretty and new they would send it back out for circulation.  What they wouldn’t do is turn around and say “Well Mr. Obama, Joe Schmo just paid his taxes so it looks like you can spend some more”.  No, the US government as a monopoly supplier of currency just presses a button regardless of whether or not you pay your taxes.  This doesn’t mean deficit spending can be reckless or doesn’t matter, but that is not today’s topic of discussion….

So what happens when we auction bonds?  Well, the NY Fed has accounts all over the country.  The Treasury keepsvery close tabs on excess reserves so as to avoid overdraft at the Fed.  So the Treasury hops on the phone with the Fed and they target some level of bond issuance necessary to soak up these reserves.  Why do they do this?  Because excess reserves drive down the overnight lending rate so if the Fed is going to maintain the Fed Funds target rate they drain the excess reserves.  Some people view this as auctioning off bonds that “fund” our spending, but in reality (because private sector net savings is public sector deficit – TO THE PENNY) it is just a monetary tool that helps the Fed hit their almighty and supposedly omnipotent target rate.

In today’s world where reserves pay interest the banks have already driven the overnight rate down.  The excess reserves that banks currently carry are not due to deficit spending, but rather the expansion of the Fed’s balance sheet.  For more on why banks are still holding excess reserves in today’s unique environment I would highly recommend reading this paper from the NY Fed which describes why excess reserves are not inflationary and also currently being caused by the Fed’s balance sheet expansion.

Getting back on topic though – much to the chagrin of the fear mongering inflationistas the auctions never seem to fail. The success rate of these auctions is unbelievably high – like shooting fish in a barrel. In fact, they are almost always oversubscribed.  Many bond market “experts” highlight the bid to cover ratio at these auctions as if disaster is imminent.  The bid to cover ratio is just the dollar volume auctioned off versus the actual receipts.  These auctions generally come in well oversubscribed.  For instance, the Treasury had three auctions yesterday.  In their 13 week treasury bill auction they issued the following results:

The Bid-to-Cover Ratio: $105,589,158,600/$27,000,182,600 = 3.91 which is WELL over their targeted levels.  Any bid to cover over 1 is sufficient to “cover” our “borrowing” costs though the fear mongerers tend to tell you that any bid to cover below 2 is worrisome (which is entirely false).  The levels are never below 1, however, because the Fed and Treasury coordinate the auctions to target the excess reserves the Treasury has already “spent”. For emphasis, the auctions are designed to succeed because they are coordinated to soak up the reserves the Treasury effectively “spent” – the same reserves they KNOW are in the banking sector and the same reserves they know they can offer a higher rate of interest on via bond issuance.

Where do these bond buyers come from?  They come from many places (in addition to the banks holding reserves – which is why they are always oversubscribed), but most important is the fact that there are excess reserves at the banks earning 0.25% and they have the option to trade these reserves in favor of higher earning assets with a marginally different risk structure.  It’s practically a no brainer trade for the banks.  Why would they not turn in their excess reserves?   The important fact here is that the money the Treasury has spent has ended up in the banking sector as excess reserves and the Fed is simply issuing bonds to soak up those reserves and maintain their overnight rate.  It’s that simple.  The auctions never fail because there is always excess reserves if there is deficit spending.

This doesn’t mean that auctions can’t fail.  The Fed could fall asleep at the wheel and stop contacting the Treasury.  The bankers could be out playing golf all day and forget that they can earn a few extra bps on their reserves if they so choose.  But in reality, auctions should never fail.  The savvy market readers will note that a UK bond auction technically “failed” in March of 2009.  But what happened after this failed auction?  Absolutely nothing.  In fact, almost every single risk asset on the planet was not only bottoming but was on an upward trajectory.  Credit markets were in the beginning stages of one of the greatest recoveries in the history of markets.  The next few UK auctions were oversubscribed and their government was able to continue soaking up reserves after the banks foolishly failed to trade in their excesses at that particular auction.

So next time you hear someone hyperventilating over a US bond auction failure (please bear in mind that the Euro currency system is different and that bond auction failures very much matter there) give them a paper bag.  Tell them to breathe into it for 10 minutes and then tell them that everything is going to be okay.  Bond auctions have no operational reason to fail.  In fact, the only reason for them to fail in the USA is due to excessive golf playing – but considering the banks have traded in their 3-6-3 model in favor of the Enron banking system I think there’s no need to worry about that.

Davos's picture
Status: Diamond Member (Offline)
Joined: Sep 17 2008
Posts: 3620
Re: When Will The Bond Auctions Begin To Fail?



but in reality the government issues money that primarily offsets the dollars they debit from the private sector via taxation


Fiscal Year ended September 2009, the average employed worker contributed $12,748 in income tax payments to the Federal government. The budget created by Mr. Orszag spent $16,809 on behalf of that same worker for: defense, federal worker salaries, Medicare, Medicaid, Social Security payments, unemployment benefits, and food stamps. Oh, and that’s just the biggest/most noticeable items in the budget. That “average” worker now has $65,237 in Treasuries debt to pay off, up from $56, 861 just eight months ago.

In reality the government takes in about 2 trillion, borrows about 2 trillion, and the service on it's debt is about 1 trillion. It spends over 4 trillion. Printing what it can't tax or borrow will do one thing and one thing only - destroy the currency.

When you can't pay your bills you are broke, you can cut or get a loan until things get better.

When you can't borrow the difference between what you take in and what you owe you are at defaults door.

When you counterfeit the difference you debase/destroy the currency.

It's so simple I fail to understand why smart people convolute this into something far to complicated and wrong.

I fail to understand why people thing deflating prices will amount to Jack when a dollar is worth nothing and they need to buy a gallon of 60%-70% imported gas or something made with oil.



hucklejohn's picture
Status: Gold Member (Offline)
Joined: Dec 13 2008
Posts: 281
Re: When Will The Bond Auctions Begin To Fail?

Here is a good link for "When Will The Bond Auctions Begin To Fail?":



Jim H's picture
Jim H
Status: Diamond Member (Offline)
Joined: Jun 8 2009
Posts: 2391
Re: When Will The Bond Auctions Begin To Fail?

Thanks Jag and Huckejohn for bringing this article to our attention... I find much of it very troubling and counterintuitive.. and my thinking is much more like that of Davos.  I understand that a bond auction will never technically "fail" if you can simply print the money to buy your own bonds... but this ultimately destroys the currency.  

I am going to study this more over the weekend myself and see if I can make more sense of it... but I would really, really like Chris to weigh in after he takes the weekend off. 


hucklejohn's picture
Status: Gold Member (Offline)
Joined: Dec 13 2008
Posts: 281
Re: When Will The Bond Auctions Begin To Fail?

I'll say "Amen" to Jim's comment about securing Chris's take on this article about the potential failure of a bond auction.  As I recall Chris has frequently written about the potential failure of a U. S. bond auction.  I know I lack understanding on this topic. 

Jim H's picture
Jim H
Status: Diamond Member (Offline)
Joined: Jun 8 2009
Posts: 2391
Re: When Will The Bond Auctions Begin To Fail?

I have been digging into this more... found what I believe to be the source of some of these ideas;


"Conclusion and proof:

Government deficit spending of $100 billion necessarily increases savings of financial assets by $100 billion."

This is just silly.  Money is debt, and I realize that the treasury is spending that borrowed money back in to the economy (unless it's being spent in a foreign country, for instance in the war effort) and ultimately back into a bank account somewhere....  But this isn't the point.  There are two overriding concepts;

1)  The scarcity integrity of fiat currency must be protected, or it will depreciate against other things of value.

2)  Debt carrying capacity is limited by one's income.  

Prag Cap says in the piece, "What happens next is where the fear mongering flat earth economists get it all wrong.  They think the Fed issues bonds to fund spending, but the US government is never revenue constrained."

But Treasury Direct says the following;

"To finance the public debt, the U.S. Treasury sells bills, notes, bonds, and Treasury Inflation-Protected Securities (TIPS) to institutional and individual investors through public auctions."


We do issue bonds to fund (deficit) spending, period.



anton95's picture
Status: Member (Offline)
Joined: Sep 29 2008
Posts: 22
Re: When Will The Bond Auctions Begin To Fail?

I did read the link to the article by the SF Fed on the dynamics of the Fed Balance Sheet.

In a way it helps explain the article in this post.

The article is right, but only in the short term.  The issuance of treasuries is assured a good reception from the banks because they have excess reserves.

However one should remember why the Treasury will be confident that the banks have those reserves. They have them because the Fed has bought up a bunch of stuff including $1.25 trillion in mortgage backed securities, which has essentially made it the market for mortgages.

The author of JAG's article is right.  The success of a bond auction is like a magic trick where you think (after another hundred billion or so) you think "How do they do that?!"  Like all good magic tricks, it involves misdirection.

Where you should be looking is the Fed Balance sheet which has ballooned to $2.4 trillion, putting banks in funds to buy treasuries (as a straight swap you have got to admit it is a great deal for the banks!).  Bank sells less than perfect MBS, gets cash.  Deposits cash with Fed at 0.25%.  Treasury offers higher rate, and soaks up cash.  Fed ends up holding imperfect MBS on its balance.  Bank is happy getting out of MBS, Treasury is happy raising funds.  Fed hold baby.

But now my friends, the end is near. The Fed is a few days from the end of its MBS purchase program.  Excess reserves of the banks will begin to shrink as they buy treasuries, and in due course this pliant artificial market for treasuries will be gone.

Let's not even think about what would happen if the Fed began to sell its MBSs (at a discount?) and shrink its balance sheet, and remove liquidity from the system, thus competing with Treasuries.

That the Treasury knows what excess reserves lie in the banking system does not guarantee a successful auction, if there are none.

Anybody who thinks otherwise is wearing a paper bag over their head.

robertsmith632's picture
Status: Member (Offline)
Joined: Jun 28 2010
Posts: 1
Re: When Will The Bond Auctions Begin To Fail?

Certainly with QE your statement is true. The Fed can just buy up all the treasuries that no one will buy, but what is the use of that? In the end the money must reach the market and circulate to create a multiplier effect. There is no value in sterilization save when the Federal Reserve fails to stop massive inflation or engages in too much QE.

sammy's picture
Status: Bronze Member (Offline)
Joined: Feb 23 2010
Posts: 35
Re: When Will The Bond Auctions Begin To Fail?

 Like I begin most of my posts, "please forgive me for the newbie questions" but here goes.


 It would seem to me that the Fed has figured out a way to keep this ride going forever if I read the OP's post correctly. So what is stopping them from doing this indefinitely? It seems that with banks buying treasuries why would we ever need real buyers in the market?  The only problem I see is anton95 says the MBS program is coming to an end soon. So what is to stop the Fed from opening the discount window again when auctions start to have funding problems? What am I missing here?


 And I want to say thanks everyone for the shot of reality that is so hard to find these days. Watching CNBC and CNN you would think we are on the fast track to recovery. Sammy

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Login or Register to post comments