Evaluating US Treasury Auction Distress
By Ron Hera
April 8, 2010
©2010 Hera Research, LLC
Investors often seek safety
from financial market turbulence in US government bonds since they offer
virtually no risk of default and, unlike cash or gold, provide a yield. At the
same time, sovereign debt default concerns outside the US, e.g., Iceland,
Dubai,
and Greece,
have been linked to short-term rallies in the US dollar and have diverted
attention from the fiscal challenges facing the US. However, since seven
US states are in worse financial condition than Greece, Ireland, Portugal or Spain, shelter may prove hard to find. With a $3.83
trillion budget, a $12.3 trillion
federal government debt, a $1.35
trillion 2010 budget deficit and $63
trillion in unfunded liabilities, the fiscal condition of the US has come
into question and foreign interest in US Treasuries has declined. In late
March, it was reported that the
10-year US Treasury Note yield had risen 30 basis points and that foreign
holders of 10-year Notes were selling in record numbers.
Reports of US Treasury
auction distress first appeared in December of 2009 when an article by Eric Sprott and David Franklin entitled “Is it All
Just a Ponzi Scheme?” questioned the “Other Investors” reported by the US
Federal Reserve. The unidentified investors held $359.1 billion worth of US
Treasuries in the forth quarter of 2008 but $880.5 billion by the end
of the third quarter 2009, an increase of $521.4 billion. Based on the Federal Reserve
Flow of Funds Report, Messrs. Sprott and Franklin found the increase
attributable to the “Household Sector”, which is defined in the Federal
Reserve’s Flow
of Funds Guide as “…amounts held or owed by the other sectors … subtracted
from known totals … [such that] the remainders are assumed to be the amounts
held or owed by the household sector.” Thus, the “Household Sector” is
strictly an artifact of accounting practices, and, as a result, there has been
some speculation regarding the parties responsible for $521.4 billion in 2009
US Treasury purchases.
A recent analysis
of 4-week Treasury auction results by OmniSans Investment Research
suggested that US Treasury auctions are more distressed than has been generally
recognized, and a similar analysis appeared on the popular Zero
Hedge website.
The OmniSans and Zero Hedge
articles focus on the percent of Treasury auction purchases made by the Federal
Reserve’s own primary
dealers, as compared with other bidders, and on the percentage of indirect
(foreign)
bids accepted. In particular, the acceptance of 100% of foreign bids suggests
extremely weak foreign demand. While the evidence is accurate, the conclusion
is less clear since the changing pattern of US Treasury auction results is more
complex.
Federal Reserve measures
designed to increase financial market liquidity and to recapitalize the banking
system, such as the Term Asset-Backed
Securities Loan Facility (TALF), represent monetary inflation (or
re-inflation), and some of this currency has certainly found its way into the
coffers of the US Treasury, i.e., a rise in primary dealer purchases. A rise
in primary dealer purchases could also be a result of the low cost of borrowing
from the Federal Reserve. In theory, primary dealers can generate profits
simply by borrowing from the Federal Reserve at near zero percent interest
rates and buying Treasuries with higher yields. Of course, primary dealer
purchases funded by borrowing from the Federal Reserve would be tantamount to
debt monetization.
An increase in primary
dealer purchases, or in purchases by direct bidders, could compensate for a
decline in foreign purchases of US Treasuries but would not explain it. To be
significant, a decline in foreign purchases would have to be evident in more
than one type of Treasury, i.e., outside of the reported 1.0 bid to cover ratio
for indirect bidders in recent 4-week Treasury Bill auctions.
What may be an emerging
pattern of falling foreign demand and rising primary dealer purchases, both of
which have been moderated by an increase in purchases made by direct bidders
(financial institutions that place bids directly with the US Treasury, such as
domestic depository institutions and mutual funds) is evident in 4-week
Treasury Bill auction results.
Direct Federal Reserve
purchases of US Treasuries (monetization) have been distributed over Treasuries
of different types and maturities and have been generally implemented as a
consistent, low-level of buying for particular Bills, Notes or Bonds. Overall,
the Federal Reserve increased its
holdings of US Treasuries by $286 billion in 2009, an increase of more than
60% as of September 2009 compared to 2008,
and, as of March 2010, the Federal Reserve’s holdings of US Treasuries had
increased another
$14 billion to roughly $777 billion.
What is important is that
monetization has been most significant in 4-week Treasury Bills, reaching
38.59% of total 4-week Treasury Bill sales on January 26, 2010, but similar
spikes in Federal Reserve purchases do not appear in auction results for other
types of Treasuries. Thus, it should come as no surprise that 4-week Treasury
Bills have fallen out of favor with foreign investors.
Of course, the amount of
currency created by monetization in a particular auction, regardless of the
percent of Treasuries purchased by the Federal Reserve, represents only a small
fraction of the monetary base. Nonetheless, there is not only a psychological
dimension but also aggregate effects on the balance sheet of the Federal
Reserve, on the US dollar and, ultimately, on the viability of US Treasury
auctions.
A general pattern of
decreased indirect bidder participation offset by rising direct bidder
participation, setting aside any increase in primary dealer purchases, is
evident outside of 4-week Treasury Bill auctions.
Foreign demand for 30-year
Treasury Bonds has fallen over the past year, suggesting that foreign purchases
may have shifted towards the short end of the maturity continuum. The more
significant fact, however, is the marked increase in direct bidder purchasing,
which has more than compensated for slack foreign demand at the extreme long
end of the spectrum leaving primary dealer purchases flat.
Given the increase in direct
bidder purchases, and reflecting on the questions raised by Messrs. Sprott and
Franklin, it seems likely that the $521.4 billion worth of US Treasuries in
2009 reflects otherwise unclassified direct bidders, i.e., direct bidders other
than recognized domestic investment funds and depository institutions.
Unfortunately, the identities of the bidders remain unknown in any case.
The most dramatic example of
primary dealer purchases replacing indirect (foreign) bidders is in Cash
Management Bills, but these represent a rolling debt of perhaps $100 billion
analogous to the corporate bond market and are not representative of other
types of Treasuries.
While there are apparent
signs of Treasury auction distress, based on a survey of Treasury auction data
from January 2009 to March 2010, there is no indication of an immanent auction
failure so long as the primary dealers and direct bidders continue to step into
the breach. Further, the same patterns either do not appear or are much less
pronounced in longer-term Treasury Note sales.
It seems unlikely that
direct bidders within the US can compensate indefinitely, or to an unlimited
extent, for falling foreign demand. Commenting on the ambitious
spending plans of the US federal government, Zhu Min, Deputy
Governor of the People's Bank of China said in December 2009 that "the
world does not have so much money to buy more US Treasuries."
It would certainly be
unreasonable for the US federal government and Federal Reserve to assume that
ambitious deficit spending and ongoing
quantitative easing (QE) would have no cumulative impact on US Treasury
auctions. If there is a limit to foreign appetite for US debt, to foreign capacity to lend to the US, or to international tolerance for US dollar
devaluation, the US government and Federal Reserve seem determined to find it.
China's foreign exchange reserves, valued at $2,399.2 billion at the
end of December 2009 (not including gold), include only $894.8 billion in US Treasury bonds.
In contrast, the US must issue or roll over $702 billion in debt in 2010 and a
total of $2.55
trillion in Treasuries to be issued this year, while $3.7 trillion in US Treasuries are
held abroad.
While US GDP
was at $14.46 trillion in 2009 (with debt
levels set to rise to 90% of GDP by 2020), China’s GDP is currently estimated
as $8.791 trillion. Although there are signs of recovery in Chinese exports,
the entire value of China's reserves, assuming that its current Treasury
holdings could be liquidated, is insufficient to finance US federal government
debt in 2010.
Since China
recently liquidated $34 billion in US Treasuries, the statement of China’s
Director of the State Administration of Foreign Exchange, Yi Gang, “[China
is] a responsible investor and in the process of these investments we can
definitely achieve a mutually beneficial result" seems obligatory. In
reality, the US is currently the largest debtor nation in the history of the
world, while China is the US’ largest creditor, and neither China nor any other country is in a position to bail out the US should US Treasury auctions run
aground. Nonetheless, an overt Treasury auction failure seems impossible with
the Federal Reserve as the lender of last resort to domestic depository
institutions and to its own primary dealers. Unfortunately, direct monetary
inflation is not without consequences. Specifically, increased debt
monetization would impact the value of the US dollar and could spark high
inflation, i.e., rising US dollar prices for imported goods and energy, or an
eventual hyperinflationary collapse of the US dollar.
Without a robust economic
recovery in the US, it seems unlikely that the apparent distress of US Treasury
auctions will abate. Among other things, the gap between increasing US federal government spending and falling
federal tax receipts is currently growing. A continuation of current US federal government and Federal Reserve policies under deteriorating economic conditions suggests
levels of debt that could not be absorbed by US creditors, and a so-called
double-dip recession would put extreme pressure on the US dollar. Indicators
of Treasury auction distress include:
- Rising Treasury yields,
regardless of interest rates, signaling inadequate demand.
- A continued decline in
foreign bids, thus a higher percentage of accepted bids, particularly in
additional types of Treasuries, outside of 4-week Treasury Bills.
- Direct bids failing to
rise at a rate sufficient to offset falling indirect bidder demand, thus
causing either primary dealer purchases or monetization to rise.
- A marked and sustained
increase in primary dealer purchases versus direct or indirect bidders.
- Additional spikes in
Federal Reserve purchases (monetization) in any type of Treasury, or a
sustained increase in Federal Reserve Treasury purchases generally.
- An expansion of the
incipient shift away from the long end of the maturity continuum towards
shorter-term Treasuries.
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