Obama Says Short U.S. Treasuries
Interest-Rates / US Bonds Feb 28, 2009 - 05:31 PMBy: Michael_Pollaro
Bank bailouts, homeowner bailouts, auto industry bailouts, and now massive stimulus packages; the Federal Government spending list goes on and on. The Federal Deficit for this fiscal year is projected by Goldman Sachs to be as high as $2.5 trillion. That's 5.5 times the fiscal 2007 Federal Deficit and 1.5 times Gross U.S. Savings. A $2.5 trillion deficit will create quite a waterfall on this graph, don't you think:
And according to our president, there is more “water” to come. Starting with his State of the Union Address, as recapped by Hans Nichols and Juliana Goldman in a February 25 th Bloomberg article, we learn:
Obama Casts Crisis as Chance to Overhaul Banking, Health Care
…President Barack Obama framed the U.S. economic crisis as an opportunity to solve some of the nation's most intractable issues...
…“The cost of action will be great,” he said. “I can assure you that the cost of inaction will be far greater.”
…Obama called for sweeping initiatives on energy, health care and education, saying they are “absolutely critical to our economic future.”
…“History reminds us that, at every moment of economic upheaval and transformation, this nation has responded with bold action and big ideas,” he said.
Not to limit these “bold ideas” to merely energy, health care and education, and to win universal support, Obama concluded by promising money for everyone:
…“I will not spend a single penny for the purpose of rewarding a single Wall Street executive, but I will do whatever it takes to help the small business that can't pay its workers or the family that has saved and still can't get a mortgage… “That's what this is about. It's not about helping banks -- it's about helping people.”
Then, on February 26 th , we see this headline on the MarketWatch website:
Obama unveils far-reaching $3.6 trillion 2010 budget…while predicting big deficits
Such is the mindset of this President, this Government and it seems the majority of the voting public. Never let a good crisis prevent you from expanding the role of Government. In my opinion, this is shaping up as the biggest expansion in Government since the days of FDR and LBJ.
What impact will this spending extravaganza have on U.S. Treasury interest rates? So far, not much; in fact quite the opposite:
The impact on U.S. Treasury rates going forward? In the final analysis, it will depend on how this spending extravaganza is funded.
Funding can come from only three places:
First up, Taxes. The recently passed stimulus packages have no new taxes. To the contrary, they will be providing “middle class” tax rebates. And while Obama's 2010 Budget proposal includes new taxes on the “rich”, its revenue potential, estimated at $640 billion by the Administration, is likely to be far less. Why's that? Higher tax rates discourage entrepreneurs from starting new business ventures and expanding existing ones. They discourage the marginal worker from taking overtime or from a spouse seeking employment to help with the family budget. Combined with unemployment insurance, they may even discourage an unemployed worker from seeking new employment. And most importantly, higher tax rates discourage people from saving and investing, especially when targeted against the rich. In so doing, they deprive the economy of the funds necessary to grow production, income and employment. Without these people, at the margin, no new tax revenue. Besides, when's the last time the Government met a revenue projection? Suffice to say that the funding for these new spending programs will largely NOT be coming from taxes.
Enter option two, more Government Borrowing. That will place the Government's funding burden directly on the credit market and by implication put upward pressure on U.S. Treasury rates. How much pressure?
Let's start by sizing the funding take relative to U.S. Savings. Fourth Quarter Federal Debt was $10,700 billion nearly 7 times U.S. Gross Savings. From a historical perspective, already a big take:
Adding another $2.5 trillion in debt, at the same savings rate, yields a Debt to Saving Ratio of 8.5, more than double the level of the last 20 years. Yes, a very big take.
But there's more. It just so happens that those pay-as-you-go Government Trust Funds, the ones with some $50 trillion in unfunded liabilities, have been a big help in funding the Government's borrowing needs for years. Why is that important? Because it meant the Government did not have to tap the credit markets, the public, for the full amount of its funding needs. In the 4 th Quarter of 2008, Government Trusts held 40% of the Federal Debt, 1.4 times 1990 levels and about double the levels seen in the 1960's, 70's and 80's:
Unfortunately, that help is waning, because the aging baby boomers, now entering retirement, are about to turn this positive dynamic into a very large negative for the Federal Government and its borrowing costs. Pressed by declining “contributors” relative to growing beneficiaries, the Trust Funds' contribution to the Federal Government's funding needs could very well have peeked at 44% of Gross Federal Debt in 2 nd Quarter 2008. Demographics suggest it's likely no maybe.
That means the public credit markets will increasingly be the source of funding for the Federal Government. Public Held Debt front and center. First some trends:
* Private, State and Local Savings, net of capital consumption on fixed assets. Excludes Federal Government
Can we say parabolic? With Public Held Debt already at a spiking 4.1 times Gross U.S Savings and an even more eye-popping 23 times Net Private, State and Local Savings, one should expect even more upward pressure on U.S. Treasury interest rates as our spend-happy Government is forced to expand its take of the public credit market.
These are pretty big spikes, you say. Forget going forward. Why are U.S. Treasury rates still plumbing historic lows? Give a big thanks to foreign investors and central banks. They do so love U.S. Treasuries. Here's the historical record of foreign holdings of Federal Debt:
That's right, over 50% of the Public Held Federal Debt is owned by foreign investors and central banks, twice the 1990's and 10x the 1960's. In fact, in this decade, foreigners have absorbed nearly 80% of the Government's Public Debt offerings. Clearly, without China , in fact all of Asia , the BRIC's and the Middle East too, U.S Treasury rates would not be at historic lows.
Which leads back to an examination of U.S. Savings. If foreign buyers have taken 80% of the Government's borrowing needs this decade, then, by definition, U.S. buyers have taken just 20%. Consider this: If foreign buyers back away, could U.S. buyers fill the void? Does the U.S buyer have the savings? Sad to say, and well-documented by numerous analysts, the U.S. savings rate has been going down, for years. The buy-now-pay-later mentality has put the U.S. in debt up to it ears. And the prospects going forward, not so encouraging, witness:
• an already saving-starved U.S. consumer facing the prospect of rising job layoffs,
• falling business profits, reflecting the weakening economy,
• mounting state and local deficits, reflecting falling income and property tax revenue,
• a Federal Reserve discouraging savings by stubbornly holding interest rates near zero, and now
• a Federal Government hell bent on making things worse by raising tax rates on income and capital.
In other words, don't expect a lot from the U.S. investor, certainly not at these low interest rates.
Now consider this: What if foreign buyers back away, at least with respect to new purchases? Yeah, I know, you heard this before. No one is going anywhere. The foreign buyer is here to stay. Consider these observations by Nauful Sanaullah in his recent essay, The Future of Gold:
But who is going to keep funding this expansion of Treasury debt issuance? The American public is broke and cannot offer its capital in return for terrible yields. Foreign nations don't have the means or will to continue financing our debt. Commodity prices have collapsed, cutting deeply into foreigners' export revenues. Oil is down from highs around $150/barrel this past summer to around $40/barrel now.
In November, China announced a $585 billion economic stimulus package to be fully invested by the end of 2010. The Chinese government agreed to provide only $170 billion of the funds. How will China raise the other $415 billion for continuous use until the end of 2010? Surely, local governments and private banks and businesses can't finance such a large package in the midst of a historic recession.
The only reserve China can tap into to finance its stimulus package is its $1.9 trillion foreign exchange reserves, $585 billion of which is in US Treasury securities. Financing its stimulus package would require selling Treasury securities, but becoming a net seller of US debt could have disastrous economic, political, and even militaristic consequences for China , so it will be interesting to see how events unfold. What seems certain, however, is that China can no longer purchase more American debt to finance the US Treasury.
This is a problem echoed by the rest of the big creditor nations. After China , the biggest holders of American debt securities are Japan , the United Kingdom , Caribbean banking centers, and OPEC nations. Japan is facing enormous headwinds as its quality-focused exports are suffering massive demand destruction as its consumers abroad lose wealth at epic proportions. Japan was a net seller of US Treasuries in 2008 and it is highly unlikely it will switch to being a net buyer anytime soon.
The British demand for American debt represented Middle Eastern oil-financed investment, but with oil prices collapsing, it will be next to impossible for this proxy demand from the UK to rise and finance additional debt. The demand for US debt by Caribbean banking centers is because of their tax laws but as the credit crunch leads to liquidity destruction in Caribbean banks, these banking centers will no longer be able to buy additional debt. OPEC nations' US debt demand, similar to the UK's, is tied to Middle Eastern oil revenues financing American consumption (of their oil exports). As oil prices tank, so will OPEC nations' economies and they too will have no wealth to buy up more American debt.
Nauful may be right. I would add that it is not just about “foreign nations not having the means or will to continue financing our debt” , but also about debt-laden U.S. consumers not having the means or will to continue consuming foreign products. For years the U.S. has printed money in return for foreign goods, with foreigners recycling those dollars right back into U.S. Treasuries. We could be nearing the end of this virtuous cycle.
For you skeptics, this is not just a theoretical argument. We may be seeing an inflection point developing now. Have you seen the shape of retail sales lately? More to the point feast your eyes on a possible turn in the U.S. Current Account:
And the crash in U.S. imports:
Before leaving this thread, there is another important trend that, in my opinion, must play out before we can declare the foreign buyer as no mas. Foreign Central Banks want out of Fannie and Freddie Agencies , and it looks like the U.S. has “obliged”, buying back those Agencies in return for a show at U.S. Treasury Auctions. According to the Federal Reserve's H.4.1 release, on July 16 th 2008 , Foreign Central Banks held $985 billion in Government Agencies, up from about $150 billion at the start of the housing bubble. As of February 25 th 2009 , they had reduced those positions to $813 billion. Over that same period, those same Foreign Central Banks bought about $400 billion in U.S. Treasuries. An upgrade, perhaps, but clearly a positive for U.S. Treasuries these last 6 months. Agency sales have been slowing of late, but this trend could have a bit more to run. On the other hand, when the run is over, all the more pressure to come on U.S. Treasury interest rates.
So where does that leave us. In Naufal's words, with option 3, Monetization:
With an insolvent public and no foreign demand for Treasuries, the Federal Reserve will monetize debt to finance its continued bailouts and economic stimulus
Great, you say. If this taxing and borrowing thing gets too hard, why not issue Government IOU's and have the Federal Reserve buy ‘em with money printed out of thin air. The Federal Government gets it's financing, and at continued low rates. Indeed, if foreigners back off, given the sorry state of U.S Savings, what choice will the Federal Reserve have?
This may work for a while, and keep U.S, Treasury rates contained. Problem is money printing means a dilution in the value, the purchasing power of the dollar. In other words, price inflation. When investors begin discounting this inflation into their buying decisions, the inflation premium demanded by U.S. Treasury buyers in U.S Treasury interest rate will rise, and rise in earnest. For who is one of the most U.S. dollar sensitive market participants in the world? Foreigners. And who is the biggest marginal buyer of U.S. Treasuries? The foreign buyer. This is an unprecedented dynamic in U.S. history. Add this dynamic to these disastrous spending, saving and funding dynamics and we could see U.S. Treasury rates explode.
You say: deflation is the concern now. There's no reason for any inflation premium. That's tomorrow's worry. U.S. Treasuries are the safest asset in the world! Investors, foreign and U.S. both, would not be piling into U.S Treasuries if they were worried about inflation. And you would be right. No one is worried about inflation. Everyone is worried about safety. And that's precisely the point. I say safety from what. If you are a contrarian, that should tell you something. Do I hear crowded trade?
What's this? Maybe those dollar sensitive foreign buyers are beginning to see the point, and are making some “adjustments”. This from a recent essay by Bill Bonner, “Hmmm... a trillion here... a trillion there...”
We are bearish on U.S. government paper - in all its forms. And here's why. The latest estimate from Goldman Sachs puts US government borrowing for this fiscal year at $2.5 trillion. Meanwhile, foreigners are showing less and less interest in U.S. debt. They're switching to short term paper - bills and notes, which are less vulnerable to inflation and currency declines …
Steve Saville, one of my favorite analysts, and proprietor of The Speculative Investor , believes gold may be helpful in flagging the point where deflation concerns abate and worries over inflation return. I agree. To start, how about a gold price break above the March 2008 highs, perhaps signaling inflation is back.
Echoing Steve's and my sentiments, Bill Bonner, in his recent essay, The United States: The Largest Ponzi Scheme in the World , did a nice job recapping the conundrum the U.S. Treasury buyer faces, and by extension how close we may be to much higher rates on U.S. Treasuries:
What is odd is that while gold goes up, so does the dollar. And so do U.S. Treasury bonds. It is as if investors couldn't make up their minds. They bid up the price of U.S. Treasuries... and bid up the price of anti-Treasuries at the same time. What gives?
On the right side of their brains, they figure that U.S. Treasury bonds are the only place you can put your money and be sure of getting it back. Stocks are a disaster. Bonds - except for U.S. Treasuries - are too risky; heck, even England could go broke.
Commodities? We've seen what can happen there... just look at oil! Even gold could easily take a 20% haircut. That's why U.S. Treasury bonds are the place to be.
But wait... the left side of the brain is sending a message too. Buy gold, it says; something fishy is going on in the Treasury bond market, it tells us. How is it possible that the feds can borrow trillions of dollars without causing interest rates to rise? How can they increase the quantity of something so much... without lowering its quality? Where's the point of diminishing returns?
One question leads to another one: 'How are they going to pay this money back?' the left side wants to know.
The more the left side thinks about it, the more it doesn't understand what is going on. Let's see... the biggest spendthrift on the planet issues trillions more in IOUs... with no obvious way to pay back the money...
...and let's see... this same spendthrift actually has the right to pay off its IOUs with more IOUs that it prints up itself...
...and it actually WANTS to make its IOUs less valuable... so that people won't hold on to them. It wants people to spend its IOUs on goods and services... as fast as possible... in order to "get the economy moving again."
'What am I missing here?' asks the left side of the brain of no one in particular.
"The rest of the world has queued up to lend America as much money as it might wish to borrow in order to get its consumers to spend again," writes Spengler in the Asia Times . "It won't work, but that is another matter..."
Spengler is a clever guy. Unfortunately, many of his thoughts are unworthy of a clever man.
"A fearful world is buying trillions of dollars of securities from the US Treasury," he continues. "Of all the cash flows in the world, nothing is more reliable than the tax revenues of the American state, the longest-lasting government on Earth presiding over the world's largest economy."
Yes, and General Motors was the world's most successful automobile company - until it wasn't. The fearful world is buying Treasuries, but not because the tax revenues of the American state are so reliable; they're buying Treasuries because the United States is the only substantial debtor in the world that can make good on its debts with money of its own making. Tax revenues in the United States are falling sharply. Already, they're far short of what is necessary to cover America 's public expenses. That's why both Republican and Democratic administrations have run deficits - real deficits - since the Nixon administration. And it's why the United States is now the largest Ponzi scheme in the world. The only way to pay off the old lenders is to bring in new ones - or run the printing press. That's all lenders have to worry about - inflation. And for the moment, prices are going down. They'll keep going down too - until they go up.
Before I wrap this up, one more table to underscore these points, this one being Federal Debt Held by the Federal Reserve:
Note the decline in Federal Reserve Debt Held as a percent of Public Debt Held, beginning in the 1980's; interestingly about the time foreign buyers began stepping up. Also interesting, note the largest percentage take occurred in the inflationary 1970's. Most importantly, observe the plunge in Federal Reserve Debt, in dollars and as a percent of Public Held Debt, in the 4 th Quarter of 2008. In fact, from a peek of $790 billion in the 3rd Quarter of 2007, Federal Reserves holdings of U.S Treasuries are off 40%. While foreigners were buying U.S. Treasuries in size, the Federal Reserve was selling U.S. Treasuries in size; you know, in exchange for Agency Debt, Mortgage Debt, Consumer Debt, and other toxic paper.
Now, look at what the Federal Reserve has done to its balance sheet, despite the help of foreign U.S. Treasury buyers:
Do we already have inflation in the pipeline? I think so. Imagine what the Federal Reserve's balance sheet, and inflation, will look like when the Federal Reserve has to step in and monetize the Federal Debt too. Now if that doesn't put an inflation premium into U.S. Treasury rates, nothing will.
My thinking, Short U.S. Treasuries. Maybe a bit early, especially if we have another deflation scare, but if you are not already in, at these historically low rates, scaling in here and now may not be such a bad idea.
By Michael Pollaro
Email: jmpollaro@optonline.net
I am a retired Investment Banking professional, must recently Chief Operating Officer for the Bank's Equity Trading Division. I am also a passionate free market economist in the Austrian School tradition and private investor
© 2008 Copyright Michael Pollaro - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
Michael Pollaro Archive |
© 2005-2012 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.
Comments
Post Comment (Moderated)