May 16, 2009
Fed plays proxy for China
By W Joseph Stroupe
Both the US Federal Reserve and the bond markets have a vested interest in seeing yields on Treasuries of all stripes remain very low, and this is especially so when it comes to the longer-dated assets. Low yields tend to keep the costs for financing government spending low.
Since quite a number of loan rates, such as home mortgages, are tied to the yield on certain Treasuries, low yields tend to bring down interest rates on key consumer and business borrowing, which then tends to liven-up seized credit. Holders of Treasuries, especially the longer-dated assets, don't want to see yields rise because that eats away at the value of their holdings. So, if the interests of the Fed and those of the bond markets coincide on low yields, where's the clash of wills between the two parties?
The clash of wills occurs over the issue of which side is going to act to keep the yields low, and over how much each side is willing to do, and when, in order to accomplish that aim. Fundamentally, if the bond markets step up to buy the longer-dated assets, meaning that demand runs high, then yields will be kept low. The converse is true; if the bond markets aren't willing to buy Treasuries at the target yield preferred by the Fed and Treasury, meaning that market demand is running lower, then yields will have to rise. Thus, the role the markets play is very potent - they are the ultimate deciders as to where yields will be.
However, with the Fed now agreeing to buy longer-dated Treasuries and other bonds and thus to stand in artificially for the markets to some extent (called quantitative easing - QE), the Fed has invested in itself the power to determine more directly where yields will be. But please note this important truth - it is the markets that forced the Fed's hand to do so, by refusing to buy sufficient sums of the longer-dated assets so as to keep their yields low.
Thus, the markets have, in effect, succeeded in turning the Fed into their own proxy, one that is low-cost and low-risk for the markets themselves. The Fed has thus succumbed to market pressures in a very significant way. It had little or no choice but to do so if it wanted to bring yields and interest rates low in order to try to get the financial and economic sectors moving again.
With QE barely more than one month old, yields on the longer-dated Treasuries have climbed above where they were before the Fed embarked upon the QE path. Hence, the bond markets are balking at purchasing sufficient sums of these assets so as to keep their yields low. And so far, the Fed has not announced that it will step up its purchases of these assets in order to drive their yields low again. Thus, the Fed and the bond markets are engaged in a proverbial game of chicken to see which side blinks first. Here is the clash of wills alluded to in the title of this article. Why are the bond markets balking now, putting increasing pressure on the Fed to blink first?
To help answer that important question it is helpful at this point to get some granularity on the answer to the question of who the "bond markets" really predominantly consist of. They include the central banks of Russia, China and much of the rest of the central banks of wealthy Asian powers, as well as rich Middle Eastern regimes, and they also include private investors in these same regions and in the US and Europe as well. Official and private foreign investors in the East traditionally hold the greatest sway in the markets, collectively accounting for the lion's share of holdings of the longer-dated assets. Only very recently have private domestic US investors made a significant showing as the US savings rate has gone from negative territory to plus 4.2% in the past few months, with Treasuries getting the nod.
It is absolutely no coincidence that directly on the heels of the multiple and strident complaints of China's leaders in February and March about the safety of US financial assets, along with a warning to the Barack Obama administration to act so as to protect the value of China's holdings, the Fed announced its QE plan, including the massive purchase of Treasuries, agencies and the like. Therefore, when I stated earlier that "the bond markets" obliged the Fed to embark upon QE, I meant that China's leaders, along with those of Russia and other powers in the East, have primarily been the ones doing so. These potent players within "the bond markets" have made it clear, in various ways, some explicit and some indirect and implicit, that they mean business.
They have been holders of large sums of agency debt (such as bonds from mortgage guarantors Fannie Mae and Freddie Mac), for example. Last summer/autumn, when the financial crisis in the US became very severe, they began dumping large amounts of agencies. Startled, the Fed and Treasury were forced to make explicit the formerly implicit understanding that these would be backstopped by the US government. And when large Wall Street banks began to go down last September, these players withdrew trillions from US financial markets virtually in one day. This led to the emergency rescue interventions by the US government as a tangible signal to "the markets" that the government would "do whatever is necessary" to preserve the financial markets and banks.
Hence, "the markets" (its dominant players being the wealthy rising powers in the East) have adequately demonstrated that their threats, whether explicit or implicit, aren't empty ones. Therefore, the implied threat to begin to divest of Treasuries and other dollar-denominated financial assets if the US government failed to protect their safety was not, and is not, an empty threat.
No one in Washington was insane enough to call the bluff of China and others in March this year. The profoundly weakened US economy and financial system could not at present endure a contest of wills with the East. So, no one in Washington had the stomach for putting to the test the popular notion that China and others in the East are stuck with the dollar and therefore could not even begin to divest of US financial assets without hurting themselves as much as they would hurt the US
Russia, China and other holders of agency debt continue to sell off these holdings, converting them mostly into very short-dated Treasuries. The move by the US government to backstop these assets (agencies) and also for the Fed to buy large sums of such bonds back from "the markets" has stemmed (temporarily) losses and has afforded the East this opportunity to divest. "The markets" are thus winning that round in the clash of wills with the Fed.
A second proxy in the East?
That brings us to the matter of Treasuries. The Fed wants "the markets" to step up to buy the longer-dated assets in sufficient sums so as to drive yields down and keep them there, but that simply isn't happening yet. The East already holds far too many of such longer-dated assets that are much more sensitive to yield/interest rate rises and which are therefore more risky. They want to hold less, not more of these assets.
But with respect to the new factor of domestic US investors that are now moving into Treasuries, these investors might already be acting, unknowingly, as yet another, new proxy for the East, one that only further affords the East an opportunity to exploit the bond markets for its strategic goals. So, for the most part, foreign private and foreign official investors are buying the very short-dated assets, as these are mostly immune to yield / interest rate rises and also afford high liquidity, and thus the ability to sprint quickly into other assets if the opportunity and/or need arise. Foreigners are shrewdly leaving the longer-dated assets to their de facto proxies (the Fed and domestic US investors) to buy.
The supply of the longer-dated Treasuries is massively increasing as the US government attempts to sell new debt to cover its ever more gigantic spending programs. These supply concerns, along with the swiftly declining appeal of these assets as a safe store of wealth against the backdrop of mounting inflation concerns, are weighing ever more heavily on all investors, but especially those in the East with large holdings. Additionally, the recent Wall Street rally, along with other tentative signs of a supposed "recovery", have recently made Treasuries less appealing as some risk appetite returns to the investor psychology. That has also driven yields up.
If the Fed is to be able to avoid blinking first and agreeing to step up its own purchases of Treasuries, it's going to have to be the new kid on the block, namely domestic US investors, who belly up to the bar to purchase large sums of the longer-dated assets. The Fed may be waiting to see if that will happen before deciding to step up its own purchases. Or, it may decide to step up its own purchases in the hope that will spur the new kid on the block to follow suit.
If the yield on these assets climbs much farther, domestic investors might buy, and then realize profits on their holdings as their collective purchases drive yields down again. If new turmoil arises in the US banking sector, domestic investors might well pull money out of banking shares and buy longer-dated Treasuries in a renewed risk aversion reflex.
Questions do remain about the ability of domestic private US investors to keep funding the Treasury in view of the massive issuance of new debt coming online and the decline in the employment rolls and in wage income. Nevertheless, if the new kid on the block wants to step to the forefront of the Treasuries game, no complaints will be heard coming from foreign investors, who will undoubtedly seize the opportunity to further roll over their own holdings of the longer-dated assets into very short-dated ones.
These foreign investors may well have calculated that if they hold back from buying such assets, the Fed and/or domestic US investors will stand in for them, working (mostly unknowingly) to protect their holdings and giving them an opportunity to convert these into safer assets. It's probably a very smart calculation.
If domestic US investors show more ability to fund the Treasury than predicted, and as the Fed buys more and more Treasuries under QE, then a period may well ensue in which the importance of foreign private and official investors declines with respect to lending to the US This period may already be beginning. Such a decline in their role and importance would be temporary (perhaps lasting from several months to a year or two), but might well become a valuable window of opportunity for such foreign investors to make accelerated moves to decrease their exposure to the dollar without triggering a dollar rout, since the Fed and domestic US investors would carry more weight in keeping the dollar afloat, temporarily alleviating the key role of foreigners in that regard.
The buying of longer-dated Treasuries by the Fed and potentially by domestic US investors would have the desirable effect of lengthening (flattening) the presently steep yield curve on sovereign US debt, making it both easier and cheaper for the Treasury to roll over the huge sums of maturing short-dated debt into longer-dated debt. That would also work to buy some time for the East to convert longer-dated assets into short-dated assets as its two de facto proxies (the Fed and US investors) carry the load of flattening out the yield curve and keeping longer-dated yields low.
The ultimate victor in the Fed/bond-market clash of wills will be the clever players in the East who see their holdings protected, at little cost and relatively low risk to themselves, while they work at an accelerated rate and in a multipronged strategy to divest of the riskier assets, accomplishing a sufficient measure of reduction of their exposure to dollar risk before the currency takes the awful brunt of the exceedingly dollar-debasing policies enacted in Washington during this crisis.
W Joseph Stroupe is a strategic forecasting expert and editor of Global Events Magazine online at www.globaleventsmagazine.com
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