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Evaluating US Treasury Auction DistressRon Hera Investors often seek safety from financial market turbulence in US government bonds since they offer virtually no risk of default and, unlike cash or gold, provide a yield. At the same time, sovereign debt default concerns outside the US, e.g., Iceland, Dubai, and Greece, have been linked to short-term rallies in the US dollar and have diverted attention from the fiscal challenges facing the US. However, since seven US states are in worse financial condition than Greece, Ireland, Portugal or Spain, shelter may prove hard to find. With a $3.83 trillion budget, a $12.3 trillion federal government debt, a $1.35 trillion 2010 budget deficit and $63 trillion in unfunded liabilities, the fiscal condition of the US has come into question and foreign interest in US Treasuries has declined. In late March, it was reported that the 10-year US Treasury Note yield had risen 30 basis points and that foreign holders of 10-year Notes were selling in record numbers.  Reports of US Treasury auction distress first appeared in December of 2009 when an article by Eric Sprott and David Franklin entitled “Is it All Just a Ponzi Scheme?” questioned the “Other Investors” reported by the US Federal Reserve. The unidentified investors held $359.1 billion worth of US Treasuries in the forth quarter of 2008 but $880.5 billion by the end of the third quarter 2009, an increase of $521.4 billion. Based on the Federal Reserve Flow of Funds Report, Messrs. Sprott and Franklin found the increase attributable to the “Household Sector”, which is defined in the Federal Reserve’s Flow of Funds Guide as “…amounts held or owed by the other sectors … subtracted from known totals … [such that] the remainders are assumed to be the amounts held or owed by the household sector.” Thus, the “Household Sector” is strictly an artifact of accounting practices, and, as a result, there has been some speculation regarding the parties responsible for $521.4 billion in 2009 US Treasury purchases. A recent analysis of 4-week Treasury auction results by OmniSans Investment Research suggested that US Treasury auctions are more distressed than has been generally recognized, and a similar analysis appeared on the popular Zero Hedge website.  The OmniSans and Zero Hedge articles focus on the percent of Treasury auction purchases made by the Federal Reserve’s own primary dealers, as compared with other bidders, and on the percentage of indirect (foreign) bids accepted. In particular, the acceptance of 100% of foreign bids suggests extremely weak foreign demand. While the evidence is accurate, the conclusion is less clear since the changing pattern of US Treasury auction results is more complex. Federal Reserve measures designed to increase financial market liquidity and to recapitalize the banking system, such as the Term Asset-Backed Securities Loan Facility (TALF), represent monetary inflation (or re-inflation), and some of this currency has certainly found its way into the coffers of the US Treasury, i.e., a rise in primary dealer purchases. A rise in primary dealer purchases could also be a result of the low cost of borrowing from the Federal Reserve. In theory, primary dealers can generate profits simply by borrowing from the Federal Reserve at near zero percent interest rates and buying Treasuries with higher yields. Of course, primary dealer purchases funded by borrowing from the Federal Reserve would be tantamount to debt monetization. An increase in primary dealer purchases, or in purchases by direct bidders, could compensate for a decline in foreign purchases of US Treasuries but would not explain it. To be significant, a decline in foreign purchases would have to be evident in more than one type of Treasury, i.e., outside of the reported 1.0 bid to cover ratio for indirect bidders in recent 4-week Treasury Bill auctions. What may be an emerging pattern of falling foreign demand and rising primary dealer purchases, both of which have been moderated by an increase in purchases made by direct bidders (financial institutions that place bids directly with the US Treasury, such as domestic depository institutions and mutual funds) is evident in 4-week Treasury Bill auction results.  Direct Federal Reserve purchases of US Treasuries (monetization) have been distributed over Treasuries of different types and maturities and have been generally implemented as a consistent, low-level of buying for particular Bills, Notes or Bonds. Overall, the Federal Reserve increased its holdings of US Treasuries by $286 billion in 2009, an increase of more than 60% as of September 2009 compared to 2008, and, as of March 2010, the Federal Reserve's holdings of US Treasuries had increased another $14 billion to roughly $777 billion. What is important is that monetization has been most significant in 4-week Treasury Bills, reaching 38.59% of total 4-week Treasury Bill sales on January 26, 2010, but similar spikes in Federal Reserve purchases do not appear in auction results for other types of Treasuries. Thus, it should come as no surprise that 4-week Treasury Bills have fallen out of favor with foreign investors. Of course, the amount of currency created by monetization in a particular auction, regardless of the percent of Treasuries purchased by the Federal Reserve, represents only a small fraction of the monetary base. Nonetheless, there is not only a psychological dimension but also aggregate effects on the balance sheet of the Federal Reserve, on the US dollar and, ultimately, on the viability of US Treasury auctions. A general pattern of decreased indirect bidder participation offset by rising direct bidder participation, setting aside any increase in primary dealer purchases, is evident outside of 4-week Treasury Bill auctions.  Foreign demand for 30-year Treasury Bonds has fallen over the past year, suggesting that foreign purchases may have shifted towards the short end of the maturity continuum. The more significant fact, however, is the marked increase in direct bidder purchasing, which has more than compensated for slack foreign demand at the extreme long end of the spectrum leaving primary dealer purchases flat. Given the increase in direct bidder purchases, and reflecting on the questions raised by Messrs. Sprott and Franklin, it seems likely that the $521.4 billion worth of US Treasuries in 2009 reflects otherwise unclassified direct bidders, i.e., direct bidders other than recognized domestic investment funds and depository institutions. Unfortunately, the identities of the bidders remain unknown in any case. The most dramatic example of primary dealer purchases replacing indirect (foreign) bidders is in Cash Management Bills, but these represent a rolling debt of perhaps $100 billion analogous to the corporate bond market and are not representative of other types of Treasuries.  While there are apparent signs of Treasury auction distress, based on a survey of Treasury auction data from January 2009 to March 2010, there is no indication of an immanent auction failure so long as the primary dealers and direct bidders continue to step into the breach. Further, the same patterns either do not appear or are much less pronounced in longer-term Treasury Note sales. 
It would certainly be unreasonable for the US federal government and Federal Reserve to assume that ambitious deficit spending and ongoing quantitative easing (QE) would have no cumulative impact on US Treasury auctions. If there is a limit to foreign appetite for US debt, to foreign capacity to lend to the US, or to international tolerance for US dollar devaluation, the US government and Federal Reserve seem determined to find it.  China's foreign exchange reserves, valued at $2,399.2 billion at the end of December 2009 (not including gold), include only $894.8 billion in US Treasury bonds. In contrast, the US must issue or roll over $702 billion in debt in 2010 and a total of $2.55 trillion in Treasuries to be issued this year, while $3.7 trillion in US Treasuries are held abroad. While US GDP was at $14.46 trillion in 2009 (with debt levels set to rise to 90% of GDP by 2020), China’s GDP is currently estimated as $8.791 trillion. Although there are signs of recovery in Chinese exports, the entire value of China's reserves, assuming that its current Treasury holdings could be liquidated, is insufficient to finance US federal government debt in 2010.
Without a robust economic recovery in the US, it seems unlikely that the apparent distress of US Treasury auctions will abate. Among other things, the gap between increasing US federal government spending and falling federal tax receipts is currently growing. A continuation of current US federal government and Federal Reserve policies under deteriorating economic conditions suggests levels of debt that could not be absorbed by US creditors, and a so-called double-dip recession would put extreme pressure on the US dollar. Indicators of Treasury auction distress include:
### Apr 8, 2010 About Hera Research: Hera Research provides deeply researched analysis to help investors profit from changing economic and market conditions. Hera Research focuses on relationships between macroeconomics, government, banking, and financial markets in order to identify and analyze investment opportunities with extraordinary upside potential. Hera Research is currently researching mining and metals including precious metals, oil and energy including green energy, agriculture, and other natural resources. The Hera Research Monthly newsletter covers key economic data, trends and analysis including reviews of specific companies. To begin receiving the latest coverage and commentary subscribe to Hera Research Monthly. Articles by Ron Hera, the Hera Research web site and the Hera Research Monthly newsletter ("Hera Research publications") are published by Hera Research, LLC. Information contained in Hera Research publications is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained in Hera Research publications is not intended to constitute individual investment advice and is not designed to meet individual financial situations. The opinions expressed in Hera Research publications are those of the publisher and are subject to change without notice. The information in such publications may become outdated and Hera Research, LLC has no obligation to update any such information. Ron Hera, Hera Research, LLC, and other entities in which Ron Hera has an interest, along with employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in these publications or web site. The policies of Hera Research, LLC attempt to avoid potential conflicts of interest and to resolve conflicts of interest should any arise in a timely fashion. Unless otherwise specified, Hera Research publications including the Hera Research web site and its content and images, as well as all copyright, trademark and other rights therein, are owned by Hera Research, LLC. No portion of Hera Research publications or web site may be extracted or reproduced without permission of Hera Research, LLC. Nothing contained herein shall be construed as conferring any license or right under any copyright, trademark or other right of Hera Research, LLC. Unauthorized use, reproduction or rebroadcast of any content of Hera Research publications or web site, including communicating investment recommendations in such publication or web site to non-subscribers in any manner, is prohibited and shall be considered an infringement and/or misappropriation of the proprietary rights of Hera Research, LLC. Hera Research, LLC reserves the right to cancel any subscription at any time, and if it does so it will promptly refund to the subscriber the amount of the subscription payment previously received relating to the remaining subscription period. Cancellation of a subscription may result from any unauthorized use or reproduction or rebroadcast of Hera Research publications or website, any infringement or misappropriation of Hera Research, LLC's proprietary rights, or any other reason determined in the sole discretion of Hera Research, LLC. ©2012 Hera Research, LLC. 321gold Ltd |
It seems unlikely
that direct bidders within the US can compensate indefinitely,
or to an unlimited extent, for falling foreign demand. Commenting
on the 
Since China
recently 