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Thursday, May 07, 2009


treasury auction trouble

today's treasury bond auction was, per john jansen,

an unmitigated disaster. The tail (tail is the number of basis points between the auction average and the levels which prevailed in cash market trading prior to the auction) was 9 basis points.

The average yield was 4.288 percent.

I am told it is trading at a profit at 4.27 percent.

This is the government bond equivalent of the GECC deal which came at a large concession yesterday.

It is so cheap to the rest of the curve that anyone who bought it is busy selling anything that is not tied down against it.

bid-to-cover was down to 2.14.

my basis of interpretation is this:

the united states government is borrowing massively to finance two programs: $700bn of fiscal stimulus to manage demand, and $700bn in wealth transfers to banks to shore up balance sheets. in order to do this, the treasury must sell a lot of debt.

meanwhile, the international market for treasury debt has shrunk rather considerably as trade flows (and therefore the american trade deficit) have contracted. in fact, per brad setser, china is now the only significant international purchaser of treasuries (see this chart specifically). china reallocated out of agencies and into treasuries during 2008, and this impulse will fade out in 2009, reducing china's treasury purchases in line with the reduction of the trade deficit. many people have worried about what would happen when net foreign demand for treasuries began to away. it is now beginning to happen.

this leaves the united states to sell the new increased pace of its debt issuance domestically. this was easy during the collapse of risk assets in 2008 and early 2009 as capital fled into treasury instruments. but now that risk appetite is increasing, where is private demand for accelerated issuance coming from?

at core, a significant part of of the end demand is coming from banks, who are seeing their customers paying down debt and building savings in response to the massive balance sheet shock of last year. these cash flows are being borrowed out of the banks by treasury in exchange for bonds.

but the differential in the size of that demand as compared to a year ago is more or less equal to the differential in consumer spending over the same period. households are redirecting cash flow from consumption to savings and debt repayment; businesses are cutting investment and expenses in a similar manner. that means the change in what the banks have to lend to the government is enough to finance approximately the amount of fiscal stimulus that would be needed to sustain demand.

now, congress did not authorize fiscal stimulus for this year large enough to compensate for the loss of private demand -- what was authorized hasn't hit the economy yet because the government has only just begun to spend it, and much of the $700bn pakcage is backloaded into 2010 and 2011. so treasury has heretofore happily financed TARP transfers to the banks and other assorted bailouts from the funds associated with lost private demand, as well as capital flight to safety. even that dynamic has tended to push longer treasury rates dramatically higher since december last year -- the ten-year yield closed at 2.074% on december 18, and is trading at 3.33% today -- despite federal reserve purchasing under the auspices of quantitative easing in march.

now the supply of bonds related to fiscal stimulus is coming onto the market as well -- and at the same time the seasonal peak of tax collections is passing. the result is an increase in the treasury's already-dramatic issuance schedule.

my as-yet-unresolved question has been whether this increase in the pace of issuance would be enough to overwhelm the cash flowing into the banks from the private sector and therefore into the treasury market, forcing rates higher -- or, more likely under the circumstances, forcing another larger round of monetization from the fed.

one can't be sure of course, but that does seem possible. savings rates have jumped by just a few percent of GDP, while treasury issuance has ballooned several percent.

UPDATE: more from jansen after the close.

UPDATE: jck @ alea:

This will be a monthly event, fasten your seat belts. Odds on, on a fail some time this year.

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Hi gm-

Interesting analysis (and it seems accurate to me). The timing of supply coming to market relative to the demand generated by savings and by bailout flow-throughs is important, and the former seems to be overwhelming the latter for now. And I expect yields are also spiking due to preference for riskier assets in the context of "green shoots" talk, as well as fears of inflation. And big money investors are only 3% bullish on treasuries and 84% bearish as of the Spring Barrons survey! Perhaps treasury shorts are causing additional temporary distortion.

I recently elaborated on some of my thoughts on treasuries for the medium term to share with some folks who've asked -- if you were to have the patience to read it and felt inclined to point out any logical flaws I'd love to hear them. You mentioned loan loss reserves before, and I understand how they impact the income statement, but as best I can tell adding reserves doesn't actually eat up cash on the balance sheet.

My guess is that in addition to the factors in my first paragraph, the TARP money simply isn't making its way back into treasuries (yet).

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i'm with you on the bid, hbl, intermediate term -- i would concur that current pricing is a temporary cash flow distortion. soon enough, the banks are going to be replete with cash. (you're right about LLR, as well -- no cash needed; it's a balance sheet item.) treasury (read: congress) has only to be aggressive about going to get it.

short term, i wonder how long the distortion can persist. primary dealers much be absolutely swamped at the moment. i don't think green shoots has much to it, and when that realization goes mainstream flight to safety will help a lot. but when will that be? yields could move higher for a bit even as cash flow into the banks gradually builds strength.

koo's explanation really convinced me of the possibility of very low demand for funds for a long time in spite of american dependency on external financing.

on the TARP funds -- are you sure they'll be recycled into treasuries? at the moment, i'd guess they're being turned into heavily discounted high-yielding securitizations as banks try to buy the net interest differential that will allow them to earn their way back to solvency as quickly as possible. maybe that's the problem with bailing out the banks so early in the correction cycle -- they aren't risk averse enough yet. of course, then the question is where to the funds go from there -- and the answer might be treasuries ultimately, but at the end of a longer chain and with more time in between.

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I appreciate your response. In my commentary that I linked to I discuss why I think any money raised by the Treasury for bailouts will have a high propensity to end up funding treasury issuance (in the context of private sector deleveraging). So even if banks buy high yield securities, what do the hedge funds do with the cash? Where do investors redeeming funds park that money? Even money markets fund t-bills. I suspect that for now the marginal demand increase isn't flowing through sufficiently into treasuries (i.e., the chain is broken for now due to stock market rally etc) but that the flow through will strengthen as sentiment shifts and available securities on offer from the private sector shrink further.

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Watch, the government needs to push rates lower for all the refinancing which needs to happen. Green shoots are making this a bit harder for them and will ultimately cause further and more difficult stresses down the line. Let's see when the government pops this bear market rally in order to bring a bit more fear into the market. I dont think they want the 30-year bond going at more than 3%. We'll see.

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