US Treasury Bonds to be Hit by $500 Billion Quarterly Flood

By: Money_Morning

Martin Hutchinson writes: The U.S. Treasury Department announced Nov. 3 that it intended to borrow a record $550 billion in the fourth quarter. That represents a staggering $408 billion increase over Treasury's borrowing estimate from early August and includes $260 billion for the recapitalization of U.S. banks.

Make no mistake about it: There will be enough U.S. Treasury bonds to choke on, as the government tries to finance this debt.

In the three months to Sept. 30, the Treasury Department borrowed $530 billion; in the first quarter of the New Year – which ends March 31 – it expects to borrow $368 billion. The March figure looks thoroughly optimistic; the monthly Treasury Statement of Receipts and Outlays shows that the first calendar quarter of the year is generally about $80 billion to $100 billion worse than the preceding fourth quarter. Thus a borrowing figure as low as $368 billion would seem to include no bailout costs and no additional recessionary costs from the current quarter.

If I had to guess, I'd assume borrowing would be about $500 billion in the first quarter, even if the U.S. banking system manages to say upright for the entire quarter – something that's by no means certain.

Interestingly, Goldman Sachs Group Inc. ( GS ) appears to agree with this. Goldman –formerly the country's largest investment banker – said last week that in the year to September 2009 the Treasury would have to borrow about $2 trillion. That would suggest a rate of about $500 billion per quarter. That figure, too, is based on a belief that the recession remains fairly shallow, and that the new administration doesn't have to add any major new stimulus programs – both pretty optimistic assumptions.

Goldman estimates that the Treasury Department will resurrect its three-year T-note issues , will speed up the issuance of two-year notes and 10-year bonds, and will "reopen" past Treasury issues that are now "off the run" (i.e. have maturities that aren't a round number of years), thus adding to the supply of nine-year Treasuries, for example.

While the gross issuance of Treasury securities has to be netted against redemptions to calculate the net increase in Treasury borrowing, $2 trillion is a lot, and net of redemptions represents about $1.4 trillion in new money. That is unlikely to come from foreign central banks, the principal source of Treasury funding in the last few years. Net foreign purchases of U.S. securities in the 12 months to August 2008 totaled $543 billion, and it was about the same in the previous year. That means $800 billion to $900 billion of new money for Treasury purchases has to come from domestic sources.

Inevitably $800 billion to $900 billion of additional money flowing from domestic investors into Treasury bonds will do three things:

• It will drive up interest rates on Treasury bonds.
• It will tend to " crowd out " other financings, making finance difficult to obtain for medium-sized and smaller companies and more expensive even for the behemoths.
• And finally, it will increase inflation, as the Fed is forced to expand money supply to give investors enough money to buy all the Treasuries.

That suggests one overpowering conclusion: Don't eat the food that Uncle Sam is trying to stuff you with in such vast quantities, except the short-term maturities if you are very hungry (have cash burning a hole in your bank account). If Treasury yields are going up, prices will drop, particularly at the long end of the maturity spectrum.  Furthermore, rising inflation makes fixed-interest-rate bonds a poor bet.

If you're really dying to own paper issued by the U.S. government, you should look at Treasury Inflation Proofed Securities (TIPS) on which interest and principal are indexed to the U.S. Consumer Price Index (CPI). These were a lousy deal earlier in the year, but yields have since risen. Now, you can get a yield higher than 3%, plus inflation protection on 10-year or 30-year TIPS. Indeed, at the 10-year maturity, TIPS yield 3.04%, whereas regular Treasuries yield 3.90%, indicating that the market thinks inflation will average only 0.86% annually over the next decade.

If the market thinks that, it's nuts. If inflation averages 7.3% over the next decade, as it did in the 1970s, a TIPS purchase will yield about 10.3% in nominal terms, about as good as you will find anywhere and far above conventional Treasury yields.

Thus, inflation-linked Treasuries are currently a much better bet than conventional Treasuries, and well worth taking a look at. You might also consider the Rydex Rydex Inverse Gov Long Bond Strategy (Juno) Fund ( RYJUX ), which invests in a portfolio of short positions in Treasury bond futures and will therefore rise in value as T-bond prices decline.

The U.S. Treasury may want you to gorge on its offerings, but in this case a strict diet is the best policy.

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

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