Unhedged Commentary
Who is really lending the U.S. all this money?
October 20, 2009
The question we must all grapple with is what will happen when the Fed has completed its purchases.
Jon Harooni |
Ravi Tanuku |
The man the US has put in charge of marketing US debt to the Chinese is fittingly named, David Dollar. Mr. Dollar, addressing a group of economic policy makers at the World Economic Forum in China last month said, “The interest rate on long-term treasury bonds is at a very low level by historical standards.” “That says that the market has confidence the U.S. will get the fiscal problem under control.” While a sub 3.5% yield on the ten-year can be construed as a vote of confidence in the US, a deeper dive into the numbers tells a substantially different and troubling story.
In the last few years leading up to our financial crisis, foreign appetite has been strong for 3 types of securities: US Treasuries, US Agency bonds (i.e. bonds issued to fund Fannie Mae, Freddie Mac, etc.), and mortgage backed securities (MBS) (guaranteed by those same government housing agencies). The allure of buying the Agencies/MBS was that investors could earn extra yield for the same credit rating and an “implied” guarantee from the US government. With the explicit guarantee today, they are, in effect, close substitutes for Treasury bonds. As such, when examining the supply/demand dynamic of the government market, it makes more sense to look at the Treasury, Agency, and MBS markets as one, competing for the same, albeit large, pool of capital. Ignoring this structural change in the market today misrepresents demand as healthier than is truly the case.
The US Treasury market bid, for example, in spite of record issuance, has been impressive. Recent TIC (Treasury International Capital) data shows that foreign investors bought a record $100 Billion of US Treasures in June, with China and Japan leading the way. Is it possible that despite a $1.6 trillion deficit this fiscal year, a $7.5 Trillion total debt burden (not including Social Security and Medicare liabilities), amid a doubling and degradation of the Fed balance sheet that the US government’s cost of borrowing has actually decreased from a year ago?
We commonly hear two main explanations for the existing bond market situation: 1) the US is experiencing a Japan-like “lost decade” and 2) the presence of a “panic trade” in the market place, neither of which seem adequate to explain the current situation.
In the 1990s, when the bubble burst in Japan, the country had a 20%+ savings rate and was one of the largest exporters into a vibrant international economy. As their assets (stock and real estate markets) deflated over 20 years, the Japanese experienced very little deflation in their CPI and actually saw inflation in their wages. The US, on the other hand, is a capital importer, with a substantial trade deficit, and 6% savings rate. The cases are vastly different.
Some market participants also believe that lower yields are a function of the “panic trade”. In effect, the US bond market has acted as a scramble to procure dollars for dollar-based borrowing given the US Dollar’s status as the world’s reserve currency. Many doomsayers predicted much, much worse and their logic was understandable: amidst a surge in US debt issuance, a dwindling trade deficit due to lower US demand for imports (which reduces the amount of dollars that Asia gets by selling us manufactured goods), money printing, and massive deficits, the most obvious trade would be for yields to spike. Yet we find yields lower than those of a year ago.
There is likely a third and potentially disastrous explanation. From June 2008 to June 2009, total foreign buying of US government sponsored debt was up $610B, down from 2007-8 level of $630B, but optically, still healthy. However, during that same time period, foreign purchasing of Agency/MBS debt was down nearly $375B. Conversely, foreign buying of short term US paper increased $325B while longer dated Treasury purchases only increased a mere $25B.
Effectively, foreigners are selling longer dated US Agency/MBS debt and moving the money they raise into shorter term US Treasury debt. And who is buying this debt? The Federal Reserve.
Out of nearly $2.1 Trillion of net issuance across the Treasury, Agencies and MBS markets from June 2008-9, the Federal Reserve has accounted for nearly 40% of the total demand, buying more than every foreign government combined. It is also not a stretch to say the Fed has become the entire mortgage market; it has purchased nearly $500B of MBS securities during a period where there was only $350B issued. Looking at the first seven calendar months of 2009 yields similarly startling results: of the total $1.1 Trillion of net issuance across these markets, the Fed has purchased $861B or almost 80%.
The question we must all grapple with is what will happen when the Fed has completed its purchases. According to the US Treasury’s Department of Debt Management, the US is expected to issue $1-1.6 T of Treasury debt in the 2010 fiscal year. This implies that total US government market issuance next year could once again run in the $2T range. To make up for the Fed’s nearly $900B worth of purchasing would require the recently elevated household savings rate to double from 6% to 12%. Commercial banks, which have purchased nearly $200B of US debt in the same time period, would also need to double that amount again from this past year.
If the Fed simply walks away or even gradually moves away from the market, we will see bond market prices drop and mortgage and all other rates go higher, potentially crushing the nascent recovery. The CEO of Wells Fargo recently told a group of investors that if the Fed stopped buying MBS, mortgage rates could spike 100-150 basis points in a week.
If the economy turns down, sparking a flight to safety in Treasuries, the Fed will once again have to worry about deflationary expectations and respond by printing money.
Unfortunately, printing more money, expanding its balance sheet further, and hoping to “kick the can down the road” may not be a viable strategy for the Fed much longer either as nearly two-thirds of the US government debt comes due in the next 36 months.
The Federal Reserve, through a confluence of past mistakes, effective crisis response, and circumstance has found itself trapped with only painful options from which to choose.
Mr. Dollar, when speaking of why countries around the globe continue to hold their reserves in dollars said, “The U.S. dollar happens to be the best choice. “It is one of the few very good places where you can put large amounts of assets and have confidence of their future value.”
Really?
Jon Harooni is currently a Senior Analyst at Glenhill Capital, a hedge fund in New York City, where he is focused on investments across the capital structure and asset classes including a focus on macro. Mr. Harooni has also worked at Copper Arch Capital, a hedge fund, and was formerly an analyst in Fidelity Investments High Yield Debt group. He began his career at Goldman Sachs in the Equities group. Mr. Harooni is a graduate of Columbia University with a degree in Economics and also a graduate of Columbia University's Graduate School of Business where he received his MBA.
Ravi Tanuku is currently a Research Analyst at Fred Alger Management, an investment firm in New York City, where he is focused on macro investments and sectors such as housing and autos. Mr. Tanuku has worked at Fidelity Investments High Yield Debt Group and began his career in the Equities Group of Goldman Sachs. Mr. Tanuku is a graduate of Columbia University's School of Engineering and Applied Science with a degree in Operations Research and also a graduate of the University of Chicago's Booth School of Graduate Business where he received his MBA.
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