SMACKDOWN WEEK: China: If you leave now...

Thanks to the readers for all the e-mails so far. Most have concentrated on the problem of foreign ownership of U.S. debt, and the potential impact on the dollar should foreigners stop funding our profligate spending.

First, let's make a distinction between debt monetization and what the Fed is currently doing with their Treasury buying program. A classic debt monetization is a solution to overwhelming domestic debt. Its printing money to actually pay off the debt because the government has no other solutions. If you want to claim that the Treasury might someday get to this point, have at it. But its clear that in the here and now, the Fed's buying program isn't meant to solve the problem of deficit spending. The Fed wants to buy Treasury bonds in an attempt to put more money into the U.S. economy in the name of fighting deflation. It might also be an attempt to force interest rates lower, although I'm increasingly doubtful that is their intention. Either way, Treasuries are just serving as the helicopter out of which the Fed is throwing money. In other words, Treasuries are a means to an end. In a monetization, buying Treasuries is an end of itself.

That being said, its legitimate for foreign investors to fear the possibility of a monetization. I can't say its out of the realm of possibility, and if your China, it would be such a disaster, they have to be watching it.

Right now, I think the U.S. and China are living in a state of mutually assured destruction. China has too much invested in U.S. dollars, and thus can't afford to have it tank. Meanwhile the U.S. has borrowed too much from China. We can't afford to have the Chinese exit.

Therefore thinking about Chinese exit is a bit like thinking about a nuclear attack during the cold war. Can't deny the possibility, but it wouldn't be in anyone's interest to allow it to happen.

How worried are foreign investors? So far they are mostly just talking. Here is the bid/cover ratio on recent 2yr, 5yr, and 10yr auctions. If the Treasury is auctioning $20 billion and the bid/cover is 2, that means they they got $40 billion in total bids.



No obvious pattern here. Plenty of buyers for Treasuries. For me, I don't take much from any given bid/cover, because a bid at any price counts. I.e., if you bid 4% for the new 10-year, that counts as a bid, even if that's actually 40bps away from where the 10-year is. But as long as the bid/cover is solidly above 1, we aren't in danger of a failed auction.

Another worthwhile auction stat to watch is indirect bidders, where foreign central banks normally hide out.



No real pattern here either.

TIC data measures foreign buying directly, but its always a little dated. Anyway, here is net purchases (buys minus sales) of Treasuries. The red line is a 12-month rolling average.



Again, no obvious pattern of selling. Now if you want to see what foreign panic looks like, check out the chart on Agencies.



The Jutland Wastes are not to traveled lightly! I've heard the Russians blew out all their Agency positions entirely, but I've also heard Chinese insurers say they'd be a natural buyer of GSE debt if it were indeed full faith and credit. Part of this too reflects an overall decline in Agency issuance, but let there be no doubt, foreigners panicked after FN/FRE conservatorship.

The overall TIC does show some pattern of decline...



But it appears to reflect a change in risk tolerance. Since overall TIC is declining while Treasury purchases are about flat, it means that foreign portfolios are more heavily Treasury weighted than in the past.

I've said before that the dollar won't have the same dominance as a reserve currency in 25 years. But I be surprised if the impact is felt in any given year. The big foreign bond buyers have come face to face with a dollar disaster. Just because it didn't happen doesn't mean it won't result in changes. But they will be long-term changes. The kind that are hard to trade on.

To those who really fear a China sell-off, my challenge is to show me hard evidence that its happening.

Treasury Market: Gonk!

John Maynard Keynes once famously said "The market can remain irrational longer than you can remain solvent."

Now, I believe in a generally efficient market, but not the one you read about in college. The textbook theory of efficient markets describes a world were security prices constantly move toward "real" value. Where information is instantly disseminated, asset, and priced into security valuation.

In real life, the "correct" assessment of information isn't so black and white. Especially since in real life, economic data is often pointing in multiple directions at the same time. Market participants must then weight various bits of data to make a valuation determination. Some will put more weight on certain pieces of data, while others will overweight other items.


This is starkly evident in the U.S. Treasury market right now. I've argued that inflation is of little concern here, despite some improvement in the economy. I point to data like today's release of Personal Income and Spending. It shows that consumers have more income to spend for the first time in 7 months. But they aren't actually spending that income: Expenditures declined by 0.1%. I've said it before and I'll say it again, there is no consumer inflation without consumers spending more money in nominal terms. Deflation is the bigger worry when consumer spending is declining.


Others take the other side, arguing that massive government deficits and the ever-running Fed printing presses will cause inflation. The dollar and foreign willingness to own U.S. Treasuries also plays into the bearish Treasury view.


The difference of opinion is especially wide now. The inflation camp suggests 10-year Treasurys rise to 6-7% or even higher. The deflation crowd currently sees a 10-year Treasury yield which is currently above typical real yield. The median real 10-year yield (just taking 10yrs minus CPI) is about 2.9% since 1989. If I assume inflation will print at or near zero in the coming months, then Treasuries seem like a deal at 3.70%. Obviously if you foresee inflation accelerating to anything above average, even something as benign as 4%, Treasury yields are far too low.

No near-term event is really going to resolve the debate either way. The economy has improved substantially since last fall, when I was writing most about deflation. Despite this, I still see a consumer preoccupied with balance sheet repair than buying new dishwashers. The inflation crowd is the same way. When the dollar was stronger earlier in the year, I didn't see the inflation crowd backing off, and why should they? Their basic thesis was still in tact.

The perception of the debate is colored day by day based on where the market is going. Friday the Treasury market was up substantially and I got a few e-mails congratulating me on my recent buy. I responded (and I blogged) that I thought it was just a month-end extension, not a validation of my view. Lo and behold, the rates market gets crushed today.

In fact, I argue that an argument always sounds smarter when its backed up by recent market moves. I can't tell you how often investment managers and traders come on CNBC and make an "argument" for a certain position that doesn't contain any argument at all. For example, if one went on CNBC and said "I think the long bond is going to 8% because inflation will spike, the Asians will dump Treasuries, and the deficit will get out of control." That's not really an argument is it? Its just a statement of cause and effect. We know Treasuries will get crushed if those things happen. The question is why might those things happen. Right? That argument is like a detective pronouncing a case closed after determining that the victim was shot. Who shot the victim is the real question.

Anyway, if you make the Treasury bear case on a day when Treasuries are getting crushed, the human mind instinctively find your argument more compelling. This guy says the Treasury market is going to get crushed, and look at it! Its already happening! If you watch, you'll notice that on any given day, CNBC tends to have more interviews with people who agree with that day's market action than not. Can't be a coincidence. It makes the casual observer feel like CNBC has on smart people!

What makes this all tough for the serious analyst is that you have to balance holding firm to your viewpoint while admitting you could be wrong. Its another way of saying that the toughest thing in investing is a sell discipline. I'm long Treasuries now (only avoided a real shellacking based on some good technical analysis). I believe in my deflation thesis, but I know I could be wrong. The inflation camp isn't stupid. There is a valid argument for much higher interest rates. The smart trader puts his ego aside and admits when he's wrong.

Many have e-mailed me asking for signposts that I'm wrong. I know what my signposts are, but I'd rather put it back on the readers. E-mail me (accruedint AT gmail.com) with the best arguments you have (could be your own, another blogger, a research report, etc.) for a significant Treasury sell-off. I read a lot of arguments myself, of course, but I won't pretend that I read everything. Send me the best stuff you have. Over the course of this week, I'll respond point by point to some of the best pieces I get. While I'm making my points, I'll also try to show the indicators I'm watching that would tell me that I'm wrong and the opposing writer is right. We'll call it Deflation vs. Inflation week! Its a smackdown!

Treasuries: Have you ever heard the tragedy of Darth Plagueis the Wise?

I remain a believer in lower interest rates. I remain of the mind that deflation is a much bigger risk than either inflation or the dollar (which is a correlated risk anyway). Still, today's move had a lot to do with month-end rebalancing. The duration of the Barclay's Aggregate has risen from 3.73 on 3/31, to 3.96 on 4/30 and now to 4.33, all on MBS extension. The MBS portion of the Agg has moved in duration from 1.54 on 3/31 to 2.22 on 4/30 to 3.16 now.

So unless rates follow through on Monday, its debatable whether this rally is real. Again, I think the thesis is in tact, but I don't know whether the market believes it or not.

Month-end buying was also highly evident in the corporate market. I came in to do some buying myself and found offerings were like pulling teeth. Since I'm not married to month-end reporting like a lot of people, I decided to roll the dice and see what the market felt like on Monday.

And the stock market? I've seen some month-end window-dressing rallies, but today took the cake.

Bill Gross: Do you trust him?

No... but he's got no love for the Empire, I can tell you that.


This morning, S&P put the AAA rating of the United Kingdom on negative outlook. Generally when S&P puts a negative outlook, it merely means they leaning toward a downgrade without any particular urgency. In this case, S&P says they need to see some progress made by an incoming British government on their burgeoning debt.


Since the U.K. is generally seen as the third most stable (U.S., Germany) of the big western economies, its not a big leap to say that the U.S. could be next. Its a perfectly legitimate concern. S&P mentions their concern that British debt could rise to 83% of GDP by 2013. In the U.S., its already 80%!

What would happen if the U.S. lost its AAA? Very hard to say. Foreign investors would still have the problem of finding someplace to put their money. I'd be surprised if the U.S. would lose its AAA rating, but say, France and Germany hold on to their ratings. Japan is already AA. It might result in a revision of how foreigners view ratings in general.


In other news, how is General Electric AA+ and stable if the U.K. needs to be downgraded? How is Assured Guaranty still AAA and stable?


Enter Bill Gross, always eager to talk his position. He stokes the fire by saying that the Treasury market is selling off due to ratings fears. Maybe. Indeed, I've heard that Asia is selling today. But always remember, when Bill Gross talks, he is always always always talking from position. So I'm assuming Gross is short Treasuries and today is adding.


I don't think really think the whole ratings thing makes sense to explain the Treasury sell-off. Here is the intra-day on Treasuries. S&P comes out with their report on the U.K. at 4:20 AM.





Treasuries are actually higher all during the Asian and European sessions, and its only once the U.S. session really gets going that the bond market sells off.

A better explanation is the continued belief that the Fed is defending some level on Treasuries. Admittedly, I thought they would, but the evidence is clear that they aren't. Here are the Fed's Treasury purchases since the program began:





Traders keep hoping the Fed will increase their POMO buys, whereas this chart clearly shows they keeping to the $7-8 billion range in the belly and about $3 billion on the long end. Their reluctance to increase purchases shows they either have no particular target or their target is much higher than where we are.

No sense in getting in the way of the Treasury negative momentum here. I'm probably not a buyer until 3.60%.

Treasuries and Stocks: If he could be turned...

Interesting to watch the Treasury market turn weaker today even as losses in stocks accelerate. I've been feeling for a while that the classic negative correlation between Treasury and stock prices will break down, at least on a day-by-day basis.

1) Any significant rise in Treasury prices will force consumer borrowing rates higher. There isn't much room for further spread tightening, especially in mortgages. So higher Treasuries probably means lower stocks.

2) Foreign buying is critical if Treasury yields are to remain low. Foreigners are more likely to buy when the dollar looks stable. The dollar is more likely to be stable if the economic picture is decent, and thus stocks advancing.

3) The stock market would probably welcome additional quantitative easing from the Fed. Based on yesterday's minutes, I expect any additional QE to be aimed squarely at the Treasury market. So Treasuries and stocks would both rally.

For what its worth, yesterday's minutes also indicated that the Fed doesn't have any particular 10-year yield in mind to defend. Or at least, if they do, that number is much higher than where we are. If the Fed cared about 3% or even 3.25%, the talk of expanding QE would have been more urgent.

Could you argue that allowing the 10-year to move from 2.50% to 3.25% is a de facto tightening of monetary policy? Maybe not, because most non-Treasury borrowing rates are lower today than 2 months ago, and thus you can't claim that credit availability has declined. However, I certainly think if they allow the 10-year to move much past 3.25%, they you will start seeing yields away from Treasuries back up as well. That will indicate tighter policy, which would be bearish for the economy.

Inflation: Not this ship, sister

Alright so the Fed isn't going to defend the 10yr at 3%, and in fact appears to be targeting the belly of the yeild curve. That doesn't change the fundamental problem of deflation. Near term, based entirely on technicals, I've made a small short play in Treasuries. But I'm really just looking for a new entry on the long-side.

Almost exactly 2-years ago, I made my now famous (in my own mind) analogy of inflation to a Monopoly game. Basically my point was inflation wasn't about the price of any given property (or good) but the price of all the properties. Allowing any given good (at the time it was energy) to rise isn't, in and of itself, inflation.


Now there is fear that the Fed and Treasury's activities, especially the Fed's recent panache for "crediting bank reserves" (which means printing money). Here is the chart for M1 and M2 up 14% and 9% respectively in the last year.

Back to my Monopoly analogy. We might think of the M's as the actual multi-colored cash that each player has. As I demonstrated two years ago, an increase in cash available should cause the price level to rise, but only if you hold the savings rate constant.


Speaking more technically, you could say that an increase monetary base would have some multiplied impact on transactable money. In your textbook from college, this only involved banks and their willingness to lend. Actually, most often text books assume banks want to lend as much as they are legally allowed, which isn't the case right now. But I digress.


The securitization market makes this all much more complicated. The supply of loanable funds isn't just a function of cash in the banking system, but also cash invested in the shadow banking system. Right now net new issuance in ABS (meaning new issuance less principal being returned in old issues) is negative, meaning supply of funds from the shadow banking system is contracting.

This contraction of funds doesn't show up anywhere in the Ms, at least not directly, but obviously it matters in terms of consumers ability to buy goods. And it isn't just about availability of credit, which had everything to do with liquidity. Its about demand for credit also. Consumers want to save, they don't want to borrow right now. The following chart of household liabilities shows consumers actually decreased their total liabilities in 2008, the first year-over-year outright decline since the Federal Reserve began keeping the data in 1952.

Consumers are like a Monopoly player who has mortgaged all his properties. Passing GO doesn't cause him to buy more houses, it causes him to unmortgage his properties! That isn't inflation!


Getting back to consumers, it isn't clear to me that consumers are actually running out of money. Check this chart of the Household Financial Obligation Ratio, basically a debt service coverage ratio for consumers.

So consumers might not have to repay debt all at once, which is nice. It means a second-half recovery of sorts remains in play. But the large losses in assets coupled with out-sized debt ratios are going to cause consumers to keep saving at an elevated level. Check out liabilities as a percentage of disposable income.

This isn't a perfect ratio, since liabilities is a stock and income is a flow. But with declining asset values (both homes and financial assets), means that consumers are actually going to have to rely on incomes to pay debt service. Or for that matter to qualify for loans. So I'd think this ratio moves back toward 100%. That implies $3.6 trillion. TRILLION. It will be repaid over time to be sure, but it will remain a continual drag on consumer spending levels.

So keep this in mind when you think about the size of Fed/Treasury programs. $3.6 trillion. Are we worried about $800 billion for the "Stimulus Package" or the $1 trillion revised TALF? Not in terms of inflation.

I'm looking forward to the day when I'm worried about inflation. It isn't today.

Fed to Treasury Market: It is you who are mistaken

Its flying a little under the radar this morning, but the Fed just disavowed the market of the notion that they would defend the 10-year at 3%. Today's Permanent Open Market action was to buy a paltry $3 billion in 10-year and longer notes.

Here are the last several POMOs of Treasury bonds (excluding TIPs)

I color coded it by the portion of the yield curve which the Fed was buying at each action. Notice that its very clear that the Fed isn't doesn't have a soft target of 3% on the 10-year. Moreover, the Fed isn't focused on the 10-year portion of the curve at all. Most of the buyer has occurred in the 4-7 year area, which I'm assuming the Fed thinks will be most influential on consumer borrowing rates.

This leaves me tactically short the 10 and longer part of the curve, looking to re-enter (I'm still a deflation believer) at a higher yield level. Technically, I don't see any stop points between 3.07% and 3.80%, so I'll probably we waiting a bit before re-entering the long-term Treasury market.

I suppose I could hot wire this thing...

I expect the Federal Reserve to announce a program to buy long-term U.S. Treasuries. If not at today's meeting, then soon. Interestingly, most commentators I read don't expect the Fed to move in this direction, but to me it seems too easy not to do it.

The Fed's big fear is deflation. We know the Fed has had the printing presses in high gear for several months now, yet still consumer prices barely move. Today we got CPI, a meager 0.2% over the last year. The cash the Fed is producing isn't turning into consumption. As I've said many times, if consumers don't spend more money, at least nominally, there can't be inflation.

Inflation nuts like to complain about the rapid growth of monetary aggregates. M2 for example has risen 9.8% in the last year, or $736 billion dollars. But note that this has almost all translated into excess reserves at banks, which have gone from about $1 billion a year ago, to $622 billion today. In practical terms, money available for consumption is falling.

If the Fed wants to create inflation, it is going to need to overwhelm banks desires for additional excess reserves. That's going to be very tough given that banks are looking at continued increases in loss reserves (despite Citi/BofA's claim that they are profitable). BCA is predicting an additional $1 trillion in losses at banks before the credit crisis is over.

To this end, the TALF is great idea. This program aims to stimulate consumer lending directly, bypassing banks, by reinvigorating the asset-backed securitization market. Already Nissan is doing an auto loan securitization tomorrow, and another major manufacturer is going to follow suit this week. These two deals will combine for $5 billion.

That's all well and good, but it won't address the problem that consumers might not want to borrow. Household liabilities are currently 134% of disposable income, according to the Fed's Flow of Funds report. In addition, households have also seen their net worth decline by $13 trillion. Consumers must continue to save aggressively in order to offset these losses. And despite what some Keynesians say, consumers need to have a decent asset base before a lasting recovery can take hold.

But a lasting recovery can't happen under deflation. Deflation has more destructive power than half the starfleet. Deflation will push home prices even lower, thus exacerbate the problem of negative home equity specifically, and wealth destruction generally.

Currently the Fed is buying Agency debt and Agency mortgage-backed securities (MBS). That program has been a success so far in bringing down spreads on those bonds, especially considering the massive flight away from these securities by foreign buyers.

But that's just the thing: the Fed has brought down the spread on these bonds. The Fed program has helped prevent mortgage rates from rising in recent weeks as Treasury rates rose. But we won't see mortgage rates actually fall until Treasury rates fall. Remember that MBS typically have servicing spread of 50bps, meaning that if investors will buy MBS with a 5% coupon, that translates into a 5.5% actual mortgage rate. So if the Fed wants to see mortgage rates at 4.5%, they have to get investors to buy mortgage bonds at 4%. Investors simply aren't going to buy a mortgage security at a 4% yield if the 10-year Treasury is at 3%.

Forcing Treasury rates lower will be relatively easy. The Bank of England has already set the precedent. On March 5, the Bank of England announced it would be purchasing up to £75 billion in gilts over the next three months. The day after the announcement, even before the first actual purchase, the 10-year Gilt had already fallen by 30bps.

When Treasury yields fall, it puts indirect pressure on all other yields. No other segment of the investing world is so instrumental in pricing so many other investments. The Fed could buy MBS, and bring MBS rates lower, then buy corporates to bring those rates lower, then buy ABS, and munis and CMBS, etc. etc. Or it can just buy Treasury bonds and bring all rates lower at once.

Not only would forcing Treasury yields lower be impactful, it would also easier to achieve. The MBS market is about $8.9 trillion and is made up of thousands of individual securities. By contrast, there is only one 10-year Treasury bond, with about $40 billion outstanding. All the Fed has to do is target the 10-year Treasury and all rates will react substantially from there.

The bubble in TBT

Just a few weeks ago, a number of commentators were calling the Treasury bond market a bubble. The 10-year Treasury had fallen to nearly 2.00%, and the 30-year bond had fallen to 2.50%. But since that time, the 30-year Treasury has risen by 100bps, representing a 19% decline in price.


Now if you really want to find a bubble, try TBT, the ProShares UltraShort 20+ Treasury ETF. This fund is designed to delivery -200% of the return of the 20-year and longer segment of the U.S. Treasury market.


First take a look at the shares outstanding in TBT. This is an excellent proxy for how popular a short US Treasury trade has become.



What's one of the conditions for a bubble? Parabolic increases in demand? The outstanding shares in this ETF has gone from about 7 million shares on 10/31 to nearly 63 million shares now.


Treasury bonds should be hitting new lows in yield. Economic and liquidity conditions are as bad as its been since the Depression. Deflation is a more serious threat than its been since that same time. Why shouldn't interest rates fall to record lows? Why shouldn't they stay there?


Yet its fashionable to scoff at Treasury rates, even now that yields have backed up. Some fear inflation, due to the massive stimuli currently being thrown at the economy. But with financial institutions as well as households rapidly deleveraging, there simply isn't enough spending to create inflation right now. Some day I hope inflation becomes a problem, but we're a good ways off from that. Consider that, according to Merrill Lynch economist David Rosenberg, that the balance sheet of U.S. households has declined by $13 trillion. The expansion of the Fed and the Treasury's balance sheet has been only 1/5 that amount.


Others fear supply of Treasury bonds. But the reality is that savings rates world wide are set to increase, creating more demand for safe assets, not less. We don't need to worry about Treasury borrowing crowding out private sector lending. Not now at least.


Finally, the Fed has a strong interest in keeping Treasury rates low. There won't be any economic recovery if mortgage rates start rising. The Fed won't be able to maintain a mortgage rate south of 4.5% if the 10-year Treasury rises above 3%.


And here is a little secret: The securitized mortgage market is about double the size of the Treasury market. It will be much easier for the Fed to manipulate Treasury rates lower than to manipulate mortgage rates!


Income-conscious investors may be loathe to buy up long-term Treasuries at current yields. Those investors should consider any very high-quality non-callable bonds: government agencies, municipals, and some corporate bonds would all make sense.

2009 Forecast Episode II: Deflation Strikes Back

This is Part II of a indeterminate series on the Accrued Interest 2009 Forecast. Here I'll focus on general interest rates and Treasury Bonds.


The question on many lips is are Treasury bonds a bubble? I've already said that fighting deflation will be the major theme of 2009. Deflation will remain the primary concern of the Fed until housing prices start to recover. I don't see that happening until 2010. Until housing prices start to rise, we'll see persistently poor final consumer demand. This in turn keeps the velocity of money low and thus the money supply contracting.


I have a very simplistic mental model for Treasury rates. Real interest rates should reflect the opportunity cost of money. Thus a short-term Treasury rate should be the opportunity cost plus an inflation premium. Longer-term rates should reflect both opportunity cost, inflation, and a term premium. When economic growth is weak, opportunities are less, and thus interest rates should fall.


If we have negative inflation, then short-term Treasury rates should be extremely low. Near zero makes sense for T-Bills (although negative yields is questionable at best). Less than 1% makes sense for the 2-year. So I see no bubble on the front end of the Treasury curve. Not that there is a ton of upside on the 2-year at 0.75%, but could it go to 0.50%? Sure.


Longer Treasury bonds are the better bubble candidates. One might be able to argue that in the short term, both growth and inflation will be negative, thus the equilibrium nominal short-term rate should probably be negative. But longer term, we'll eventually have both growth and inflation, and thus long-term Treasuries should not be approaching Japanese-like levels.

So when the 10-year was pushing 2%, it felt bubbly. But still I resist the bubble label. To me, Treasury rates are clearly below "fair value" but given the extreme liquidity and economic circumstances, I doubt the 10-year can move above 3% until at least 4Q 2009. I think long-term Treasuries remain over-valued until its obvious that inflation is going to eventually become a problem.

What about Treasury supply you ask? Won't the massive debt load eventually push rates much higher? While acknowledging that supply is an obvious negative for prices always and everywhere, as it is, Treasury supply is clearly not overwhelming demand. The 3-year and 10-year auctions from last week went quite well.

Besides the theory that government debt crowds out private investment doesn't hold water right now. Private lending ain't happening in areas where the government isn't subsidizing. In essence, the Treasury is leveraging because the private sector can't.

Eventually, the Fed's programs will result in much higher inflation, and thus Treasury rates will rise substantially. But I think this is a year or more away, too far away to recommend a short.

The problem for real money investors is that Treasury yields are so low, that you pretty much have to own something else. The yield advantage on short-term Agencies versus short-term Treasuries is so large that there isn't any logical scenario where the Treasury outperforms. Therefore I'm playing this by remaining underweight Treasury bonds, but owning stuff that can appreciate if Treasury rates fall. This includes bullet agencies, and some very high quality corporates.