A town in California blighted by the real-estate bust is having the sun burnt lawns of foreclosed homes sprayed with green paint to create the illusion of prosperity; now the Fed is spraying the tattered US economy with Greenbacks to create a similar illusion. The question is: why now? The answer is: because foreign buying of Treasuries is drying up, a development I've been flagging as inevitable for a while now. Even if foreign official buyers like central banks had a continued appetite for US debt exposure, the fact is that their trade surpluses have collapsed with US import demand. Asian merchandise exporters and OPEC have far smaller dollar surpluses to recycle into US debt markets this year even as supply soars; their purchases of agency debt started slumping last Summer, forcing the US government's hand on Fannie and Freddie; now Treasury buying is also slumping as shown in the chart below. This coincides with Japan facing a trade deficit for the first time in decades, and China seeing its surplus collapse from $40bn in November 2008 to $4.8bn in February 2009.
As these countries have been the two biggest official buyers of Treasuries, the Fed is understandably nervous facing a fiscal deficit at 12% of US GDP to finance. I've never been in the depression/deflation camp, simply because the Fed could always inflate it's way out of trouble if necessary, and underlying CPI data suggests deflation is a remote possibility; service inflation in key areas like health care and education is still running at 4-5%. February’s top-line CPI rose 0.4pc, equivalent to 4.8pc annually, while core consumer prices also rose, by 0.2pc; the Cleveland Fed’s median CPI was 2.8pc above the previous year. Ten year TIPS implying just over 1% inflation (up from nothing back in November) are a great bet. We've lost maybe $40-45trn in global wealth over the last 18 months, or almost four times the annual output of the US economy. The Fed has now unleashed its most powerful weapon, planning to monetize $300-billion of Treasury debt and an additional $750-billion of MBS guaranteed by Fannie Mae and Freddie Mac, bringing its total purchases of these securities to $1.25 trillion. I had warned in recent e-mail alerts and last week's podcast of the possibility of the Fed following the BOE and SNB into quantitative easing, and the huge risks involved in shorting bonds, noting the bubble in short Treasury ETF retail interest. The only surprise was that the market was so surprised.
China owns an estimated $1.7-trillion in US-dollar assets, comprising $900-billion of Treasury bonds and short-term bills, $550-billion in agency bonds, $150-billion in corporate bonds (where demand is also falling, see chart below), $40-billion in US-equities, and $40-billion in short-term deposits. China’s dilemma is that any effort to unload a significant part of its massive Treasury and agency holdings could trigger a selling panic, with devastating impact on the value of its foreign currency reserves. China and the US are locked in the economic equivalent of the Cold War doctrine of Mutually Assured Destruction. If China stops buying it needs to worry about the Fed monetizing the debt, which could lead to serious inflation and a bond market rout, as the US-economy stabilizes. Then again, if that's happening anyway...this week, it seems to me that the Fed felt compelled to pre-empt a looming funding crisis, as the buyer of last resort for US debt, taking full advantage of the dollar's current status as the global reserve currency.
To put that Fed $300bn announcement in perspective, note that the debt outstanding in the 2-year to 10-year sector is just under $2.2 trillion, with an average coupon of about 4% and an average maturity of 5-years. With a 4.5 modified duration assumption, that works out to weekly Treasury buying of $12.5 bn nominal and $6.5 bn in 10-year equivalents. In other words, the Fed’s looming purchases are only just enough to offset the growing supply from the new and extremely high levels. Although domestic demand is growing rapidly with the US savings rate and bank balance sheet demand, I suspect the market has over-reacted, and US yields will trend up again if we see a poor auction in coming weeks reflecting the ongoing weakness of overseas demand. Unless they print even more money of course...
