Monday, March 02, 2009

Treasury Bubble?

One of the hot topics of the moment is Treasuries - who's gonna buy then as the US debt levels explode and the Fed wants to keep rates low? The consensus seems to be that China and other major current account surplus nations will slow or stop their purchase of US Treasuries due to our deteriorating balance sheet and revenue generating power and low rates on offer. As US credit quality declines, rates will have to back up to 4-5-6% to get current holders to keep buying. The US has an enormous amount of Treasuries to fund in the next two years, $2.5t in 2009 alone, the most ever.

China and friends continued to be big buyers of T's in 2008, but were not as dominant as we might have expected based on all of the bearish T chatter. Work completed by Brad Setser at Council on Foreign Relations ( suggests that private investors bought more T's than the world's central banks in 2008. In fact, "Central bank demand (in 2008) accounted for a far smaller share of total issuance than in the past few years. In 2007, for example, central bank purchases easily exceeded total issuance. The big increase in demand for Treasuries in 2008 came from private investors in the US."

As central bank reserve growth slows/reverses, they will certainly buy fewer T's in the coming quarters. With the credit market panic in Q4, much of the central bank purchases were a trade out of agency debt, suggesting that the real demand in 2008 for T's by central banks was exaggerated. So the question of who will finance the US Treasury at the low rates the US Government needs is up to individual investors more than central banks.

Setser goes on to say, "A world with $1750 billion US fiscal deficit and a $500 billion US current account deficit only works if Americans are willing to buy an awful lot of Treasuries. The borrowing need of the US government is now far too big to be covered by the (much reduced) growth in the emerging world’s reserves." this suggests that developments in the T market in 2009 will driven by developments in the US, not abroad.

What conditions would drive greater private investment in T's in the US? An ongoing decline in the equity markets, further increases in corporate defaults and declines in corporate bond markets, increasing savings rates, a shift by boomers out of equity into fixed income... Deleveraging the consumer balance sheet alone will free up billions of dollars of savings that will likely find a greater attraction to safe T's. With a little help from Ben buying some 10 year T's in the market as a part of QE and we'll begin to set a ceiling on rates.

All of this has implications for a few trades. First, I think Ben's move is close, and a short term bond rally is not too far away. That's good for corporates as well, but they may suffer under greater spreads as defaults rise. It's also good for the dollar in that the "day of reckoning" of net T/$ selling by central banks is not near. Plus, what other currency are you going to buy? This review, however, is not a refutation of the long term outlook for the US $ and T's: as soon as the velocity of money makes a comeback ('10?'11?'15?), inflation will be our focus and rates will shoot up, making any long term investments in T's a gamble. Then again, we may see real growth for a decade...


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