Treasury Bonds without a Safety Net

The on-going deficits forecast for the US cannot be financed out of domestic savings.  The shortfall must be covered via  foreign funding or the Federal Reserve monetizing the debt. The Fed has announced that its purchase of Treasuries will stop at $300 billion. That limit was reached last week. If one believes the Fed, they are done (monetizing), and the safety net under Treasury auctions has been removed. Without this backstop, there is risk of a failed Treasury auction, an event that could prove cataclysmic to financial markets in this country and around the world. As discussed by Graham Summers:

A little known fact (and one totally ignored by the mainstream media) is that the Fed accounted for nearly half of all Treasury purchases in the second quarter ($164 billion out of $339 billion). In fact, the Fed bought more Treasuries than the next three largest purchasers combined!!

In simple terms, these numbers indicate that if it were not for the Fed, the US Treasury market would have almost assuredly had numerous failed auctions in the second quarter. It also shows us that foreign holders (China, Japan, etc.) are reducing their purchases of US debt at an incredible rate.

The Treasury is scheduled to sell $78 billion in debt obligations this coming week. This number is large historically, but not large in light of recent and forecasted government spending/taxation. Deficits, including off-balance sheet items, will be about $ 2 Trillion this fiscal year. Additionally, about $2 Trillion of existing debt must be re-financed each year. Debt auctions must average about $80 billion per week, week after week after week ad nauseum or ad failed auction.

The dependence of the US on foreign governments to finance our deficit is the Achilles heel of both the dollar and the Treasury bond markets. Will it be possible for the Fed to stop buying Treasuries? Unlikely. If they stop and failed auctions occur, interest rates rise, damaging the housing and economic recovery. If the Fed continues to monetize (buy Treasuries), the dollar will continue to decline, perhaps precipitously. The Fed (and the US government) is nestled uncomfortably between the classic “rock and a hard place.” Chris Martenson’s take on this subject is summarized below:

The US government continues to have impressive borrowing needs, but the Federal Reserve has claimed to be done with its program of buying US government debt.

At the same time, the truly spectacular inflows of foreign dollars into US Treasury paper cannot logically continue forever, especially given the collapse in export markets.  There is even some mystery as to how they could have been as large as they’ve been.

Taken together, it would be logical to suspect that US Treasury paper and new debt issuances would come under some pressure, which we would detect as falling bond/note prices and rising yields.

However, that’s not at all what we are currently seeing, as indicated by the 10-year note yielding a paltry 3.2% and recent auctions have had more than three buyers biding for each bond.  The question before us is, can we see anything that might cause this to change?

I would submit that the US lacks sufficient domestic savings and productive capacity to finance its fiscal deficits internally so I propose that there are only two paths forward.  Either foreigners continue to finance the US deficits, or the Fed will resort to even more printing to cover the shortfall.

Where will the foreigners get the money?  Alternatively, how will they react if the Fed simply prints up the difference?

The dollar/bond market is unsustainable for the long-term, but may last for a while longer. It is highly unlikely that foreign Treasury demand will meet US deficit needs. It is even more unlikely that the Fed will allow the government to start bouncing checks.  Hence, the Fed will continue monetizing the debt, either openly or surreptiously. Eventually the unsustainable equilibrium represented by today’s dollar and interest rate structure will adjust to reality. Watch these markets closely because the next phase of the crisis will emanate from one or both.

Related Posts

Post a Comment