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.