Who Will Buy the Debt?

"Who will buy Treasuries when the Fed doesn’t?" is a question asked by major bond fund manager Bill Gross of PIMCO in his March 2011 Investment Outlook. Gross has come under considerable scrutiny for daring to divest his flagship Total Return bond fund of Treasury holdings post the late August QE2 announcement by the Fed/Bernanke, and in some timeframes thereafter apparently took short positions against Treasuries.

Despite the significant rally in Treasuries from mid-April, with a near 18%/10% decrease in the 10-yr/30-yr yields (leading to ~6-7% price appreciation on the market), Gross has essentially maintained his low-to-no position on Treasuries, with a 35% holding in cash equivalents, 21% mortgage debt, 18% high-grade corporate debt, and 20% equally split between emerging and developed market (mostly government) debt, shying away from municipal debt in a similar manner to Treasuries. Gross maintains he has "no regrets" over missing the recent Treasury rally, and recommends that bond investors should shift their weights to corporate or government debt issued by companies and sovereigns with far better balance sheets than the U.S. government (and also by implication, municipalities).

I submit the larger, more general question at this point should be: "Who will buy the debt?" Though debt-holders have continued (or have been forced) to de-lever from the credit market excesses that eclipsed in 2007/8, record debt issuance continues in the corporate markets and from the U.S. Treasury [1], thanks to historically low rates led by the Fed's zero interest rate policy (ZIRP) and ongoing permanent open market operations (POMO, or debt monetization).

Low yields mean investors may not be adequately compensated for the aggregate risks they are taking by buying the issued debt. Those risks include default, interest rate and inflation risks. The latter is already an issue: the real rate on the 5-yr Treasury note is currently negative [2]. Though default risks are in real terms lower for many high-grade corporates vs. our own sovereign debt, the current talk of sovereign default from Greece to the U.S. increases this risk span, yet rating agencies still rate Treasuries as AAA and the corporate-to-Treasury spreads are increasing as Treasuries rally. Interest rate risk (the risk that interest rates shoot significantly higher, sending bond prices sharply lower) is a real possibility that could lead to a broad market "event" not dissimilar to the Black Swan-type swoon we saw in 2008/9, except this time Treasuries may lack the "flight-to-quality" status that investors then sought for sanctuary while the stock, commodity, and non-government bond/debt markets all got pummeled. In this scenario, investors and traders may choose to dump some or all of their debt holdings (including Treasuries and munis), preferring not to get caught as prices fall, and therefore may trigger a cascade of selling and even sharper declines in prices.

As total outstanding debt continues to grow and yields are kept artificially suppressed, investors must ask why they should risk buying any debt if there is market volatility risk attached that could stem from default and/or interest rate risks. "Who will buy the debt" is the hazard for debt oversupply in any market, with markets increasingly correlated due to leverage and other factors.

[1] Total outstanding U.S. bond market debt as of Q1/2011 stands at some $35.5T, composed of $9.1T Treasury debt (26%), $7.6T corporate debt (22%), $8.5T mortgage debt (24%), $2.9T muni debt (8%), $2.9T money market debt (commercial paper, etc.)(8%), $2.5T federal agency debt (Fannie/Freddie, etc.)(7%), and $2T asset-backed debt (auto, credit card, home equity, student loan, etc.)(5%). The trend of this data since 2007 has clearly shown an increase of Treasury and corporate debt, and a leveling-out or decrease of all other types of debt, from the credit market deleveraging process. This data was sourced HERE from the Securities Industry and Financial Markets Assoc. (SIFMA). U.S. bond market debt is some ~39% of the total world-wide market debt estimated at ~$92T using Bank of International Settlements (BIS) data HERE. Note that these stats are total outstanding "market" or marketable/tradable debt, and not total outstanding market+non-market debt. I will discuss and source the latter in a future commentary, but the obvious example is the non-marketable U.S. Treasury debt that includes social security obligations, state and local government series bonds and savings bonds. 
[2] The U.S. Treasury has a nifty interactive yield curve flash app HERE, showing nominal vs. real rates and a historical rate comparison tool.

Beware of 'Peg the Dollar to the Euro' Proposals

In a cure for what is being forecast as a recession after the end of the Federal Reserve's latest targeted quantitative easing binge (QE2), Nobel Laureate Robert Mundell has proposed that the Treasury fix the exchange rate of the dollar to the euro. Mundell believes that a sure sharp rise in the dollar post-QE2 will lead to deflation in the U.S., and then recession. His prescription for this scenario is to stabilize currency exchange rates, given his view that exchange rates transmit inflation or deflation into economies by raising or lowering prices for imported items and commodities. By targeting a peg of the dollar to the euro, the world's two leading currencies, greater economic stability will be achieved.

I say that this is an absurd idea. Fixing the exchange rate of the dollar to the euro does not equate to currency stability. I also take issue with the dynamics that Mundell may be using in his argument: commodities don't always correlate with the eurodollar, so fixing the dollar to the euro won't necessarily affect commodity speculation and hot money flows across borders and back. The problem is with mismatched credit expansions and interest rate policies between borders - causing money to flow preferentially to the highest yielding opportunities at that moment. We have a very fluid and liquid global system now, and swing trading based on these mismatches in policies is quite obvious. We live in the realm of the carry trade, wherever it can be found.

Would an international gold standard help? Not if it isn't supported by a commitment to maintaining its stability, and I doubt that commitment exists at present. For one, it would mean credit could not expand or contract too drastically, and I do believe there are some highly placed who want such a turbulent environment. The other issue is interest rates, which are already monopolistically fixed by sovereign central banks - this is another control not likely to be easily ceded. A stable international gold (or hard money) standard and "free banking" are ideals for the distant future, and the benefits are worth continued extolment.

Failed Fed Auction an Early Warning?

Not widely reported except by Bloomberg, the Federal Reserve (Fed) had a rare failed auction last week of mortgage-backed securities (MBS) "purchased" by the Fed from AIG during its $182.5B bailout in 2008/9. The Fed bought a total of $52.5B of MBS from AIG as part of the bailout package, forming the "Maiden Lane II" portfolio of distressed crisis assets on its balance sheet. Why should investors and traders care about this event? Keep reading.

In a June 8 dutch auction, investors only bought $1.9B of $3.8B of debt offered, causing market spectators to question the quality of MBS assets that AIG dumped on the Fed (or that the Fed overpaid for). The byline is that the Fed ended up selling the assets into a weak(ening) market, a casualty of bad timing. The irony is that the Fed was offered $15.7B from the rescued-and-lingering AIG for repurchase of the remaining $31B Maiden Lane II portfolio in March. Perhaps the Fed saw such a discount repurchase (reverse repo, actually) as a giveaway that would get too much press attention as a taxpayer loss, and decided that selling into the open market was a more tenable option. Credit markets in February-March were at a 2-year "high" of health, but have since deteriorated somewhat, with both MBS and corporate high-yield (junk) debt spreads increasing along with the price of credit default swaps for major banks and bond insurers.

So why should investors and traders care about this event? First, failed Fed auctions are a rarity. Second, the Fed has some $2.8T of "crisis assets" on its balance sheet [1], with ~$2T collected since fall 2008. Yes, the majority of those assets are Treasuries bought via quantitative easing asset swaps, and are AAA-rated, of the very highest quality debt (for now). Likely, the Fed won't be unwinding its balance sheet anytime soon, given some show of recent economic weakness and calls for even more quantitative easing from some quarters. The questions that arise are: Is selling into a weak market a destabilizer for credit/debt markets, and what is the risk of more failed auctions as the perception of quality deteriorates? Could those failed auctions ever be mint-Treasury auctions by the Treasury [2], forcing the Fed to continue loading its balance sheet and monetizing debt? And then there's always the question of all that muni-debt...

Note I am not just another "chicken little" on the issue of failed auctions and bond market turmoil, as the quality of debt has always been, and always will be, the paramount concern. If the 2008 crisis taught us anything, an oversupply of debt in the market can have destabilizing consequences, especially if quality of that debt declines. Investors and traders need to be vigilant of any signs of worsening conditions.

[1] Public view of the Fed's balance sheet can be found HERE.
[2] Newly-issued Treasury auctions can be tracked HERE.

Japan's Downgrade is Bearish For U.S. Treasuries

The recent rally in U.S. Treasuries has many of us wondering when the trend is going to end. One party disruptor may be Japan, a major foreign creditor holding some $900B of U.S. Treasury debt, second only to China, who holds ~ $1.15T. Japan may yet decide to liquidate some of its holdings to divert capital to post-tsunami rebuilding efforts or to invest in higher yielding debt or other investments elsewhere.

Japan's recent sovereign credit rating downgrades are perhaps warranted, but a tad nonsensical in comparison with a lack of an actual downgrade of U.S. sovereign credit. Though Japan's government debt/GDP approaches ~220% of GDP, the U.S. debt/GDP at ~100% of GDP is growing at a much faster rate and does not account for unfunded obligations that will easily exceed projected tax revenues.

The Yen carry trade that financed arbitrage-fancy T-bond purchases is not as lucrative as it once was, given the persistent strengthening of the Yen (USD/JPY is now trading again below 80). Given the U.S. debt profile, sitting on long-term U.S. debt has growing risks unless hedged. The Bank of Japan could see a sale of Treasuries and a purchase of higher yielding debt from other countries with stronger currencies as a prudent move as Treasuries continue to push higher on what I call a technical rally.

(Major foreign holders of Treasury securities are tracked by the Treasury here: http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt.)

James Grant on Bernanke

“Bernanke is the anti-Benjamin Graham, Graham being the great value investor. For Benjamin Graham, value was everything, price was a way of getting at value. For Bernanke, price is everything, value is an annoyance, value is what holds prices down. I think that investors should keep an extra margin of cash to exploit the opportunities that may well come from an unscripted rise of inflation that sets off a chain reaction in interest rates and brings values back down to earth. Nothing is sweeter than buying cheap stocks, and they do get cheap from time to time.”

–James Grant, Value Investor and Publisher of Grant's Interest Rate Observer, March 31, 2011 on Kudlow & Co., CNBC

Japan's New Inflation

A few weeks ago Japan reported rising inflation, with the CPI gaining 0.3% and 0.6% YoY in March and April, after years of negative monthly CPI data. The headlines from major news outlets were indeed amusing: "Japan beats deflation for the first time in two years (BBC)," "Japan Ends 25 Months of Deflation in Victory Marred by Quake-Led Recession (Bloomberg)," and my personal favorite, "Why inflation is great news for Japan." Oh wait - that latter title is recycled from a myriad of similar news reports when inflation last surfaced in Japan in 2007/2008.

According to business/economic news media and Keynesians alike, inflation for Japan is good, while deflation is an anathema. Inflation means rising consumption, demand, loan growth and ultimately output, while deflation means falling consumption, demand, credit contraction and deleveraging, and ultimately falling output. Except the dynamics aren't that simple and settled.

Japan's persistent YoY deflation since 1995 is arguably the result of years of debt deleveraging from the '80s real estate and stock market boom-then-bust, but it is also the result of rising production and productivity [1], which has a positive effect on lowering overall consumer price levels, even when demand is increasing. One might call this "good deflation." Also overlooked is the fact that Japan's deflation was "low and stable," especially during the period 1998-2007, when the average annual YoY CPI deflation was -0.23% with a standard deviation of 0.49%. I find it contradictory that the bulk of economists (especially those residing at central banks) think that low and stable inflation is good (the "Great Moderation"), while apparently low and stable deflation is bad.

What Japan's experience with inflation proves is that rising prices can happen with falling output and productivity, or stagflation, a dirty word to garden-variety Keynesians. With the Yen recently strengthening against most major currencies, the Bank of Japan is limited in what it can do to weaken its currency, which in the past has been achieved though a plethora of quantitative easing measures. Japan has little choice but to continue to delever and fight off any potentially persistent high rates of inflation, should it arise.

[1] Japanese industrial production and labor productivity rose steadily from 1998-2007, aside from a break in the increase during the 2001 recession. CPI and production/productivity data for Japan were sourced from HERE.

 

Money Market Funds and Risk

Money funds carry risk, and taxpayers should not be expected to bail out poorly managed funds.

Are money market funds safe investments? With yields at historic lows the question is a good one to ask, especially if the risks outweigh the yields. The highest current yields may only be slightly over 1%, with the bulk of funds yielding far less than 1%. At such low yields, some consider these funds not as an investment, but as a place to reserve or "park" cash. Money market funds typically peg their net asset value (NAV) to $1/share to "guarantee" against principal loss, though in reality there is no inherent guarantee, and these funds are distinctly different from bank savings accounts.

Regulators, such as the SEC, are reportedly working on (you guessed it) more regulation of money funds, with possible reclassification as banks, and perhaps even the charter of a new FDIC-like entity to buy securities from the funds in liquidity, flight of capital, or quality of capital crises. The industry's trade group is even lobbying the SEC and the Federal Reserve to set up a "liquidity bank," one that would have access to the Fed's discount window.

A history lesson is useful here. The money funds that had trouble in Fall 2007 had bought short-term commercial paper from structured investment vehicles (SIVs), which in turn used this funding to buy risky/toxic collateralized debt obligations (CDOs) and mortgage backed securities (MBSs) - In effect to circumvent regulatory capital rules that restricted debt. The value of these SIVs plunged with CDO/MBS prices, imperiling the value of that paper. There were about a dozen money funds in this timeframe that suffered from potential losses and "breaking the buck," and some of them were names that would later succumb to essential failure or takeover (e.g. Wachovia). The problem funds simply replenished their capital to avoid further market turmoil.

In Fall 2008, the problem resurged, with one fund, the Reserve, the flashpoint - for holding some 1.2% of their assets in paper (debt) from Lehman after the bankruptcy. The irony with the Reserve fund is that it was started by the so-called creator of money funds, Bruce Bent, who in 1972 opened the first money fund to "invest in a diversified group of short-term credit instruments." Bent promoted the idea of maintaining the $1 NAV to attract investors interested in total preservation of capital. The irony is that Bent was also a staunch advocate "against the dangers of reaching for higher yield by stooping to inferior credits...denouncing commercial paper as overly risky." A run on the Reserve immediately following the Lehman bankruptcy (savvy investors noted the 1.2% interest in Lehman paper on the fund's websites) prompted Reserve management to "frantically seek help from the Fed." [Source for historical info: R. Lowenstein, "The End of Wall Street," c.2010.]

The Reserve Primary fund has since liquidated all assets after an SEC-ordered pro-rata distribution, with shareholders getting back ~0.9875 cents on the dollar.

My commentary: Does anyone read prospectuses and keep track of fund investment holdings? Money funds may promise a $1 NAV, but in practice many not be able to keep it, especially if they buy commercial paper secured by faulty collateral or credit. The same goes for any other poor-quality short-term debt. Money funds carry risk - and it rewards investors to seek funds that are conservative compared to others.

Not all commercial paper is "bad;" what matters is the collateral behind it. If it is a diversified set of solid businesses with solid balance sheets, great - but if it is Ponzi finance, such as SIVs seeking short-term funding to buy suspect MBSs to juice the yield spread, then something is wrong.

Money fund investors need a dose of caveat emptor, even with the perceived safety of more regulation, which may also mean even lower yields due to increased regulatory costs.

As for the idea of a liquidity bank, it's a fine one, and investors who have a perceived need for such a service or insurance should elect to pay for it. Allowing money funds to access the Fed's discount window in times of stress is akin to a taxpayer subsidy, given the discount rate charged for any liquidity.

 

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The Econ Ideal was created to provide frequent commentary (and some analysis) on current economics, finance, trading and investing subjects. Stay tuned for new posts. The peer site for this blog is http://www.econideal.com. For more information about me, the author, see http://www.econideal.com/p/about.html.

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