Evaluating US Treasury Auction Distress

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Evaluating US Treasury Auction DistressBy Ron HeraApril 8, 20102010 Hera Research, LLC

Investors often seek safety from financial market turbulence in US government bonds since theyoffer 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 beenlinked to short-term rallies in the US dollar and have diverted attention from the fiscal challengesfacing 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 $12.3trillion federal government debt, a $1.35 trillion 2010 budget deficit and $63 trillion in unfundedliabilities, 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 yieldhad risen 30 basis points and that foreign holders of 10-year Notes were selling in recordnumbers.

Chart courtesy ofStockCharts.com

Reports of US Treasury auction distress first appeared in December of 2009 when an article byEric Sprott and David Franklin entitled Is it All Just a Ponzi Scheme? questioned the OtherInvestors reported by the US Federal Reserve. The unidentified investors held $359.1 billionworth of US Treasuries in the forth quarter of 2008but $880.5 billion by the end of the thirdquarter 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 isdefined in the Federal Reserves Flow of Funds Guideas amounts held or owed by the othersectors subtracted from known totals [such that] the remainders are assumed to be the
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amounts held or owed by the household sector. Thus, the Household Sector is strictly anartifact of accounting practices, and, as a result, there has been some speculation regarding theparties responsible for $521.4 billion in 2009 US Treasury purchases.

A recent analysis of 4-week Treasury auction results by OmniSans Investment Researchsuggested that US Treasury auctions are more distressed than has been generally recognized, and

a similar analysis appeared on the popularZero Hedge website.

Chart courtesy ofZero Hedge

The OmniSans and Zero Hedge articles focus on the percent of Treasury auction purchases made

by the Federal Reserves ownprimary dealers, as compared with other bidders, and on thepercentage of indirect (foreign) bids accepted. In particular, the acceptance of 100% of foreignbids suggests extremely weak foreign demand. While the evidence is accurate, the conclusion isless 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 thebanking system, such as the Term Asset-Backed Securities Loan Facility (TALF), representmonetary inflation (or re-inflation), and some of this currency has certainly found its way into thecoffers of the US Treasury, i.e., a rise in primary dealer purchases. A rise in primary dealerpurchases could also be a result of the low cost of borrowing from the Federal Reserve. Intheory, primary dealers can generate profits simply by borrowing from the Federal Reserve atnear zero percent interest rates and buying Treasuries with higher yields. Of course, primarydealer purchases funded by borrowing from the Federal Reserve would be tantamount to debtmonetization.

An increase in primary dealer purchases, or in purchases by direct bidders, could compensate fora decline in foreign purchases of US Treasuries but would not explain it. To be significant, adecline 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 Billauctions.
http://seekingalpha.com/article/190362-something-very-strange-is-happening-with-treasurieshttp://www.zerohedge.com/article/its-going-implode-buy-physical-gold-nowhttp://www.zerohedge.com/article/brace-impact-2010-private-demand-us-fixed-income-has-increase-elevenfold-or-elsehttp://www.newyorkfed.org/markets/pridealers_current.htmlhttp://www.newyorkfed.org/research/current_issues/ci13-1/ci13-1.htmlhttp://www.ny.frb.org/markets/talf.htmlhttp://www.ny.frb.org/markets/talf.htmlhttp://www.newyorkfed.org/research/current_issues/ci13-1/ci13-1.htmlhttp://www.newyorkfed.org/markets/pridealers_current.htmlhttp://www.zerohedge.com/article/brace-impact-2010-private-demand-us-fixed-income-has-increase-elevenfold-or-elsehttp://www.zerohedge.com/article/its-going-implode-buy-physical-gold-nowhttp://seekingalpha.com/article/190362-something-very-strange-is-happening-with-treasuries


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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 (financialinstitutions that place bids directly with the US Treasury, such as domestic depository institutionsand mutual funds) is evident in 4-week Treasury Bill auction results.

Chart 2010 Hera Research, LLC

Direct Federal Reserve purchases of US Treasuries (monetization) have been distributed overTreasuries 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 increasedits holdings of US Treasuries by $286 billion in 2009, an increase of more than 60% as ofSeptember 2009 compared to 2008, and, as of March 2010, the Federal Reserves holdings of USTreasuries 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 inFederal Reserve purchases do not appear in auction results for other types of Treasuries. Thus, itshould come as no surprise that 4-week Treasury Bills have fallen out of favor with foreigninvestors.

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 themonetary base. Nonetheless, there is not only a psychological dimension but also aggregateeffects on the balance sheet of the Federal Reserve, on the US dollar and, ultimately, on theviability of US Treasury auctions.

A general pattern of decreased indirect bidder participation offset by rising direct bidderparticipation, setting aside any increase in primary dealer purchases, is evident outside of 4-weekTreasury Bill auctions.
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Foreign demand for 30-year Treasury Bonds has fallen over the past year, suggesting that foreignpurchases may have shifted towards the short end of the maturity continuum. The moresignificant fact, however, is the marked increase in direct bidder purchasing, which has more thancompensated for slack foreign demand at the extreme long end of the spectrum leaving primarydealer 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 reflectsotherwise unclassified direct bidders, i.e., direct bidders other than recognized domesticinvestment funds and depository institutions. Unfortunately, the identities of the bidders remainunknown in any case.

The most dramatic example of primary dealer purchases replacing indirect (foreign) bidders is inCash Management Bills, but these represent a rolling debt of perhaps $100 billion analogous tothe corporate bond market and are not representative of other types of Treasuries.
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While there are apparent signs of Treasury auction distress, based on a survey of Treasury auctiondata from January 2009 to March 2010, there is no indication of an imminent auction failure solong as the primary dealers and direct bidders continue to step into the breach. Further, the samepatterns either do not appear or are much less pronounced in longer-term Treasury Note sales.

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It seems unlikely that direct bidders within the US can compensateindefinitely, or to an unlimited extent, for falling foreign demand.Commenting on the ambitious spending plansof the US federalgovernment, Zhu Min, Deputy Governor of the People's Bank of Chinasaidin December 2009 that "the world does not have so much money tobuy more US Treasuries."

It would certainly be unreasonable for the US federal government andFederal Reserve to assume that ambitious deficit spending and ongoingquantitative 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 Reserveseem determined to find it.

Chart courtesy ofZero Hedge

China's foreign exchange reserves, valued at $2,399.2 billion at the end of December 2009(notincluding gold), include only $894.8 billion in US Treasury bonds. In contrast, the US must issueor roll over $702 billion in debt in 2010 and a total of$2.55 trillion in Treasuries to be issuedthisyear, 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), Chinas GDP is currently estimated as $8.791trillion. Although there are signs of recovery in Chinese exports, the entirevalue of China's reserves, assuming that its current Treasury holdingscould be liquidated, is insufficient to finance US federal government debtin 2010.

Since China recently liquidated $34 billion in US Treasuries, the statementof Chinas Director of the State Administration of Foreign Exchange, YiGang, [China is] a responsible investor and in the process of these

Zhu Min, Deputy Governor,People's Bank of China

Yi Gang, Deputy Governor,People's Bank of China
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investments we can definitely achieve a mutually beneficial result" seems obligatory. In reality,the US is currently the largest debtor nation in the history of the world, while China is the USlargest creditor, and neither China nor any other country is in a position to bail out the US shouldUS Treasury auctions run aground. Nonetheless, an overt Treasury auction failure seemsimpossible with the Federal Reserve as the lender of last resort to domestic depository institutionsand to its own primary dealers. Unfortunately, direct monetary inflation is not without

consequences. Specifically, increased debt monetization would impact the value of the US dollarand could spark high inflation, i.e., rising US dollar prices for imported goods and energy, or aneventual hyperinflationary collapse of the US dollar.

Without a robust economic recovery in the US, it seems unlikely that the apparent distress of USTreasury auctions will abate. Among other things, the gap between increasing US federalgovernment spending and falling federal tax receipts is currently growing. A continuation ofcurrent US federal government and Federal Reserve policies under deteriorating economicconditions suggests levels of debt that could not be absorbed by US creditors, and a so-calleddouble-dip recession would put extreme pressure on the US dollar. Indicators of Treasuryauction distress include:

Rising Treasury yields, regardless of interest rates, signaling inadequate demand. A continued decline in foreign bids, thus a higher percentage of accepted bids,

particularly in additional types of Treasuries, outside of 4-week Treasury Bills.

Direct bids failing to rise at a rate sufficient to offset falling indirect bidder demand, thuscausing either primary dealer purchases or monetization to rise.

A marked and sustained increase in primary dealer purchases versus direct or indirectbidders.

Additional spikes in Federal Reserve purchases (monetization) in any type of Treasury,or a sustained increase in Federal Reserve Treasury purchases generally.

An expansion of the incipient shift away from the long end of the maturity continuumtowards shorter-term Treasuries.

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http://www.ft.com/cms/s/0/6bae5044-2be5-11df-8033-00144feabdc0.htmlhttp://finance.yahoo.com/news/Nearly-half-of-US-households-apf-1105567323.html?x=0&.v=1http://www.heraresearch.com/newsletter.htmlhttp://www.heraresearch.com/newsletter.htmlhttp://finance.yahoo.com/news/Nearly-half-of-US-households-apf-1105567323.html?x=0&.v=1http://www.ft.com/cms/s/0/6bae5044-2be5-11df-8033-00144feabdc0.html


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Evaluating US Treasury Auction Distress