As we move into the new year, institutional investors are faced with a quandary that I believe they never imagined they would have to face. A SHORTAGE of US Treasury bonds. Yes, you read that one correctly, a SHORTAGE. That's because the Fed announced yesterday that starting in January 2013 they're planning on purchasing 90% of all the new issuances of US Treasury Bonds. That'll come out to about $450 Billion a month, and that's on top of the $400 Billion per month they're already spending on buying up Mortgage-Backed Securities.
The simple economics of this plan is that both the Federal Government and the Federal Reserve know that when yields are down and supply is up, prices for new issuances would be extremely low. As I've stated in previous columns, investors today do not purchase US Treasury Bonds in order to increase the value of their portfolios. Quite the contrary. For each new issuance of the Federal Deficit they purchase, they're actually LOSING money when you factor inflation and the time-value of money into the equation. The one thing that US Treasury bonds DO have going for them is that they come with very little risk of default. In fact, I would argue, that unlike most fixed income products out there on the market, US Treasuries are the most likely to retain most of their value through maturity. Therefore, the market value of US Debt is quite high when compared to the sovereign debt of other nations around the world, including Germany. Further, in the insurance industry, companies are REQUIRED to hold a certain percentage of their books in US Treasuries so that they can protect you, the insurer against future claims. That makes US Debt very attractive for those investors who wish to buy and then re-sell into the market.
The problem for the US Treasury is that we're producing too much of it. A $1.5 Trillion deficit (plus replacements for matured issuances) translates to about $500 Billion per month. The simple rule of supply and demand is that if there is too much supply and too little demand, then prices will go down. The combination of low yields and low prices will rapidly put US Treasuries into the "junk bond" category, and we can't have that, can we? So the US Government has three options in front of them. They can 1) Cut spending, 2) Raise yields, or 3) pretend there isn't a problem by printing more money. Well, we can take #1 off the table, and #2 would be suicidal so we're only left with option #3, right? After all, the governments of the Euro zone don't have option #3 available to them and just look at what's happening to them!
Therefore, the Federal Reserve will now be adding $850 Billion to its balance sheet every month so that we can go on pretending that we're not spending ourselves into oblivion. Just to put that into perspective, $850 Billion would pay off 85% of all Student Debt in this country. Less than half of that would fix ALL of America's crumbling infrastructure, plus leave plenty of money left over to build a fifty-foot sea wall around New York City.
So who's really benefiting from this Federal Reserve largess? Why, it's their friends on Wall Street, of course. That's because companies like Goldman and CitiGroup get first dibs on all new US Treasury issuances. By the time they're done, there won't be any bonds left for the rest of the market. Therefore, they're free to charge whatever they want. For companies who cannot afford these over-inflated prices, they're stuck going out into the market to buy BBB securities or, even worse, get into the derivatives game by creating their own synthetic investment vehicles, which doubles their exposure and their risk.
When the bubble pops, and it's only a matter of time before it does, 2008 will look like a minor market correction in comparison.
