Toxic Treasuries Redux

While the equity markets are reacting positively to whatever bit of good news they can grab, economists are eying  thewing-prayer market for government bonds.  The United States and the United Kingdom have huge deficit driven budgets and stimulus plans that are testing the willingness of their creditors.  The US is skating on the thin ice.  The UK fell into the pond.  This from Market Watch:

NEW YORK (MarketWatch) — Treasury bond auctions, not usually the stuff that fires up equities traders, rocked stocks this week as investors homed in on worries about the ability of the government to borrow more than $2 trillion to fund its financial and economic rescue plans.

On Wednesday, concerns were sparked after the U.K. failed to get enough bids to sell the full amount of 4-year gilts it offered, the first time this happened in 14 years. Later in the day, a U.S. government auction of $34 billion of 5-year notes drew only tepid interest from foreign investors.

“Everybody knows that the government is auctioning stuff like there’s no tomorrow,” said Paul Nolte, director of investments at Hinsdale Associates. “The question is who’s going to buy all this stuff,” he said. “If there’s not enough buyers, interest rates will have to go higher, which means mortgage rates would have to go higher and that could derail any recovery we might have.”

Treasury bond yields, which move inversely to bond prices, are used to benchmark the interest rates on many consumer loans, including some mortgages. When buyers don’t show up at an auction, bond prices fall and their yields rise.

This brings us back to China and their call to review the dollar’s role as a reserve currency.  The offset on the Fed’s balance sheet to Treasury Bills and Bonds is dollars.   These things and the interest rates that prevail in the economy are causally linked.  You mess with one, you mess with them all.

Meanwhile, China, the largest buyer of U.S. Treasury bonds, expressed concern earlier this month about the safety of its investments. The massive amounts of U.S. debt issued have pressured bond prices and also threatened the strength of the dollar, which could further reduce the value of holding Treasurys.

China also rocked the boat when the governor of its central bank on Monday called for a new global reserve currency to replace the dollar.

The Treasury had announced that the would be heavily involved in the market this week.  The FED is also out there with its quantitative easing program.    Odd things are happening.   It became obvious by mid Wednesday that their announcements and actions were causing the Treasury to actually buy at  high price mid-morning then selling much later at a low price.  It doesn’t take a rocket scientist to know that’s bad math for the taxpayer.    Larry Doyle over at NQ heard that Wall Street was trying to sell three times the amount that the Treasury actually bought.

Bloomberg also noted the supply concerns.

The Treasury Department is selling a record $98 billion in notes this week, eclipsing the record $94 billion auctioned the week ended Feb. 27. The U.K. failed to attract enough bidders today at an auction of 1.75 billion pounds ($2.55 billion) of gilts for the first time in almost seven years.

President Barack Obama’s government is selling record amounts of debt to revive economic growth, service deficits, and cushion the failures in the financial system. Debt sales will almost triple this year to a record $2.5 trillion, according to estimates from Goldman Sachs Group Inc.

Orders for U.S. durable goods unexpectedly rose by 3.4 percent in February, the Commerce Department said today in Washington. Purchases of new homes in the U.S. unexpectedly jumped in February, increasing 4.7 percent to an annual pace of 337,000 after a 322,000 rate in January, Commerce said.

“Better than expected economic data, failure of the long- end auction in the U.K. and low demand at the five-year Treasury auction; all these factors combined are leading to higher yields,” said Anshul Pradhan, an interest-rate strategist in New York at Barclays Capital Inc., another primary dealer.

The Fed said it purchased $7.5 billion of U.S. debt spread among 13 of the possible 19 securities eligible for purchase. The notes mature from February 2016 to February 2019, the Federal Reserve Bank of New York said in a statement today. Nearly $22 billion was submitted to the central bank in the first day of buying, the New York Fed said.

“We are really not seeing any kind of meaningful support for the Treasury market,” said Kevin Flanagan, a Purchase, New York-based fixed-income strategist for Morgan Stanley’s individual investor clients. “Conventional wisdom in the market is that the Fed will concentrate on the five- to 10-year or the seven- to 10-year sector.”

Japan, the UK, and the US are all purchasing an extraordinary amount of government debt.  Members of Parliament were seriously unhappy with Gordan Brown’s plan for continued deficit spending and here’s an example of that incredible exchange.  The failed UK auction was perhaps a harbinger of things to come.

Geithner continues to put in a mixed performance as Treasury Secretary.  While generally putting on a good show at congressional hearings and receiving a rally from Wall Street for releasing details on the TARP, he managed to send the dollar down with a slip of the lip.

The dollar fell the most in almost a week against the euro on concern Treasury Secretary Timothy Geithner supported a Chinese plan to blunt demand among global central banks for the U.S. currency. The dollar weakened as much as 1.2 percent to $1.3651 per euro, the biggest intraday decline since March 19, before trading at $1.3601 at 4:20 p.m. in New York.

Geithner later affirmed the dollar’s role as the world’s reserve currency.

“The poor communication from the Treasury department has complicated the market for Treasuries,” said Baker Group’s Caughron.

The WSJ reported that so far, the market is handling the issuance. However, you may want to watch the UK because we maybe seeing similar speeches, moves, and auction failures in the near future.

Eventually, the sheer volume of issuance could overwhelm the market, causing a back-up in yields, but it has not happened yet. In fact, yields on short-term bills have actually dropped into negative territory. On previous occasions, when this happened, it was one of a number of signs of worsening credit conditions, but key short-term stress indicators remain “well-behaved,” according to Zach Pandl, economist at Nomura Securities International. That, along with the improved health in stocks, suggests investors are piling into short-term debt because the end of the quarter is approaching.

“With bill rates at negative yields today it suggests there’s still intense demand for U.S. securities,” says Mr. Pandl. “We’re expecting a huge amount of issuance and borrowing from Treasury this year … that is going to be putting upward pressure on rates, but as of now the market is still willing to buy Treasurys.”

We’re unlikely to see upward pressure on interest rates as long as a few situations hold.  First, the Fed must continue to be more concerned with unemployment and economic growth than with inflation and continue a policy of easy money.  Second, private demand for loans must remains sluggish.  If we see any competition for loanable funds in the loan markets, this will potentially ‘crowd’ out business investment and leave more of the impetus for recovery back on the government. Third, we need the SWFs–especially China–to continue to buy and hold Treasuries.  If any of these circumstances change, all bets are off.

In a more interesting and immediate note, the yield on the one month Treasury went negative today.

The U.S. one-month Treasury bill yield slipped into negative territory for the first time since mid-December, indicating rising risk aversion on continued concern about the U.S. economy and the stability of the financial system.

“The fear reached the point where investors didn’t feel safe keeping their money in the banks and were willing to pay the government for short-term protection and the safety of T-Bills,” said said Andrew Bekoff, chief investment officer at Family Office Group LLC.

geithnerThe three month yield has been sitting at a 50 year low.  This indicates a lot of money is still sitting on the side lines, despite the current ‘run’ on Wall Street.  It also shows how much money might still be playing it safe.  Companies are not looking to expand any time soon.  However, we could hope that since  it’s near the end of the quarter, some companies may be window dressing their balance sheets so they look more liquid when they report.  After that, they may draw cash balances down but it may not be used to expand business.