Brad Setser

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Last week’s move in the Treasury market …

by Brad Setser
March 22, 2009

When financial historians get around to writing the history of the great crisis of 2008 (or great crisis of 2007-09?), they will no doubt focus on the collapse of the market for securitized mortgages — and in reality, almost all forms of credit risk. The corollary of that fall, though, has been the rise in the price — and fall in yields — of comparatively safe financial assets. And US Treasuries are still considered safe.

The first year of the crisis was marked by three upward spikes in the price — and sharp falls in yield — of short-term Treasury bills: one in August 2007 (subprime, quant funds), one in the spring of 2008 (Bear) and one in September 2008 (Lehman, AIG, Merrill and in all probability nearly every other financial institution but for the extension of a government backstop to the system).

The ten year Treasury bond didn’t really rally until late November, well after Lehman. It then soared (i.e. yields fell) in late 2008 before selling off this year — before the Fed stepped in.

My guess is that gyrations in the ten year bond will mark the next stage of the crisis. Bank bailouts — and counter-cyclical fiscal policies — are very expensive. Last week the CBO confirmed what students of Reinhart and Rogoff already suspected. But the Fed rather clearly doesn’t want yields on the ten-year to head back to the 3.5-4.0% range of early last fall. Not when the economy is weak.

Christoph Schmidt is concerned about the risk of future inflation in the US. But the Fed — like Jan Hatzius of Goldman and Dr. Hamilton of UCSD — is far more worried about the immediate risk of deflation. And with so much spare capacity globally, I tend to agree with the Fed. German industrial production is now down over 20% y/y. Eurozone output is now almost 20% below its level a year ago. And parts of Asia — like Taiwan — are in even worse shape.


  • Posted by black swan

    We hear from the St. Louis Fed that all this money that’s being created out of thin air (trillions of dollars) has not found its way into the economy, and thus, there is no inflation. The Fed claims that when the economy heats up again, and this credit finds its way back into the system, that the excess dollars will get mopped up with the expirations of short term notes and other magical methods known only to the brilliant bankers and economic professors who run the Fed. This is how the Fed intends to stop inflation dead in its tracks. We hear from Denninger that we will have an economic collapse and continued deflation. In other words, the conventional wisdom is that there will be no inflation until the economy is growing again, and that the Fed can stop it if or when that inflation emerges. The conventional wisdom, however, may not be all that wise.

    While the Fed and many others are saying that US inflation will only take place through the front door of a recovering economy, there are many more foreign dollar debt holders out there who could bring about US inflation through the back door of panic selling their USD debt, and then using the proceeds of those debt sales to buy up the world’s commodities as well as some bargain basement priced US real estate. Foreign entities will dump the dollar before its value evaporates, and that will increase the money supply within the US economy. There would be nothing the Fed could do about it. I’m not sure this wasn’t the Fed’s plan from the beginning. After all, who really runs theFed?

    It is ironic that just after Chinese Premier Wen warned the US not to devalue China’s two trillion in USD investments, the Fed announced that it will buy its own country’s long bonds. That announcement resulted in an instant USD devaluation against other currencies and PMs. There are many sovereign wealth funds and foreign investors sitting on trillions of dollars who can’t be very happy with having to watch their USD debt investments devalued by the Fed and the Treasury. Exchanging those dollars for commodities and US assets will drive up the prices of both. Import prices will also rise. Even with Americans losing jobs and being paid less for the jobs they still have, the cost of living in the US would still rise for them. The PM buyers have already figured this out. They are preparing for the US dollar’s homecoming.

    I’m already getting my butt kicked competing with German real estate buyers in Cape Coral, Fl. A stronger euro will only serve to make those buyers more aggressive. It doesn’t hurt the strength of Deutsche Bank, when AIG funnels over $12 billion in US taxpayer money into it to make good on credit default swaps that probably only have a market value of $600 million. It is not impossible that, as Americans walk away from their homes, foreign investors with stronger currencies pick up those properties for €0.10s on the euro. Future discounts could make commercial real estate bargains even more lucrative for foreign investors. The TARP banks could then unload their toxic paper and weak collateral to foreign investors, as the surviving IBs, Goldman Sachs and Morgan Stanley, combined with JPM and Wells Fargo, control what would be left of America’s best assets. The US banking barons would get in the game, personally, by cherry picking the best assets and buying them up with the stronger currencies from their foreign financial opperations. The transfer of wealth will finally be complete.

  • Posted by Rajesh

    We would love it if some of the central banks sold their currency reserves and bought commodities. The U.S. government pays interest on the Treasury bonds that the central banks holds. Gold, copper and iron ore cost us nothing. Federal Reserve has already shown that it is willing to ignore commodity inflation so long as it does not feed into core inflation.

    If the money that is currently locked up in currency reserves were instead in circulation then the Federal Reserve would have less need to expand its balance sheet. The Federal Reserve is fighting the tendency of consumers, businesses and central bank to save instead of spending.

    Given the sagging real estate prices, those German buyers should be given a kiss. If they want to buy high and sell low, they deserve a thank you for supporting our economy. They should hurry, though, the Euro is getting only a brief respite from the pummelling it is taking. We may see parity between the Dollar and Euro this year.

  • Posted by Stefan

    Cash is a zero-maturity government bond. The Fed is just exchanging longer-dated bonds for shorter (=cash). This is not the big thing.

    The big thing is the budget deficit. That is where idle money becomes flowing money. Currently the budget deficit is running at 150 BUSD per month. That is, on average 500 USD is handed out to every American per month.

  • Posted by Stefan

    If 300 BUSD Chinese Treasuries turns into a 300 BUSD claim on reserves at the Fed, nothing will happen.

    When 300 BUSD of Treasuries are sold, and the proceeds are distributed all over the economy, adding multiplier effects – a lot is happening.

    However, to the extent Fed purchasing affect yield-sensitive bond-holders, their demand will turn to other assets, and a certain fraction will stimulate the economy.

  • Posted by Cedric Regula

    Brad:”But the Fed rather clearly doesn’t want yields on the ten-year to head back to the 3.5-4.0% range of early last fall.”

    The Fed got 2.2% last Christmas from Santa Gross (when the Fed first announced QE as an option in November), and briefly got 2.5% last week from Paul McCulley’s Easter Bunny.

    But the bonds masters at PIMCO are sounding a bit ambivalent about things lately.

    There is some chance the Fed move towards QE will backfire. The thing that gave me some confidence that the Dollar would hold at current levels and the USG would be able to fund this year’s fiscal and monetary expansion was the “lack of safe global choices” argument. The Fed may be chipping away at this belief too much, based on market reactions last week(other than US bond markets). $300B isn’t very much compared to the size of the market, so the Fed needs to pay attention to long term inflation and dollar expectations. Right now they are almost begging the Chinese to sell into Fed purchases over the next 6 months, and get out of the dollar whilst the gittin’ is good.

    I had really expected a global coordinated move towards QE, but the eurozone continues to be a holdout. Some will say this is a big mistake, they are “behind the curve”, etc… but what if our Fed convinces people they should finance the eurozone the old fashioned way…buy euro government bonds?

    Whether Yurp can survive such provincial thinking remains to be seen. The euro just moved from 1.25 to 1.35 in an eyeblink. That won’t help the “output gap”. But it may at least fund the safety net.

    But can what we are doing help the “output gap” anywhere? Roubini and many others long ago described this crisis as more of a “solvency” problem than “liquidity” problem. I see no mention of this anymore, but the combined fiscal plus monetary stimulus is $4T. We could buy all the foreclosed houses at the projected 20% defaults of the $11T mortgage market and declare a rent holiday (I’m trying to impress Krugman with my liberal thinking), and that would only cost $2T. So where is the bang for the buck in the USG program?

    One possibility is there is no fix. A strong one in my opinion, since we have global overcapacity that was put there to support a credit bubble. Now we have necessary deleveraging in the financial sector. On top of that we sold phony insurance and gave out phony credit ratings to keep interest rates at an artificially low level. Then we did everything possible to undermine mortgage loan quality. This is coming to an end. Then we had cheap money re-cycled from the trade deficit helping to hold down interest rates. That loop is drying up.

    TALF is already projected to fail. No one wants to borrow money to buy bad assets. DUH!

    The Fed should just come to grips with the fact that you can screw some of the people some of the time, but you can’t fool Mr. Market all of the time.

  • Posted by Don the libertarian Democrat

    “they will no doubt focus on the collapse of the market for securitized mortgages — and in reality, almost all forms of credit risk. The corollary of that fall, though, has been the rise in the price — and fall in yields — of comparatively safe financial assets. And US Treasuries are still considered safe.”

    I’m still not sure that I’ve yet heard a good explanation for this. I assumed in September that, after Lehman, everyone was operating under the assumption that we might fall into a Debt-Deflationary Spiral, beginning with a Calling Run. That’s what led to the Flight To Safety, and then Lehman caused a serious problem by leading to the belief that implicit guarantees might not be honored. I still believe that, but there are lots of other explanations. It seems a real puzzle, especially since the jitters about these problems seemed to begin in August.

    One of my main points about this is William Gross missing out in the US Treasury moves. Since then, he’s been doing very well. I assume that he believed that the government would not allow Lehman to fail and would honor implicit guarantees. Since then, he’s been betting, and making money, assuming no more Lehmans and that the government is honoring guarantees.

    As for China, they made clear that they agreed with Gross. What puzzles me to this day, is that, since Bernanke feared Debt-Deflation, he allowed Lehman to go under. I’m starting to feel that he really didn’t feel that he could save them.

  • Posted by Chritian

    Being scared of deflation is not relevant at all. The Fed is governed by a man who mentionned he was ready to unload dollars from an helicopter if need be. Why then worry about deflation? It is so easy to get ride of it in a fiat currency system. No the big problem is inflation, now of course no one wants Americans to worry too much as it would only increase inflation expection hence that focus on deflation is just a tactic to keep bond yields as low as possible.

  • Posted by black swan

    “What puzzles me to this day, is that, since Bernanke feared Debt-Deflation, he allowed Lehman to go under.”

    I don’t see it as any accident that there are only two IBs left, and that one of them is Goldman Sachs. What surprises me is that John Mack hasn’t joined Jimmy Cayne, John Thain and Richard Fuld in the multi-millionare’s unemployment line.

  • Posted by Cedric Regula

    Don LD

    Bernanke was asked during his 60 minutes interview why he didn’t save Lehman. He said it was because the Fed is not allowed to make loans without taking collateral.

    Mull that one around a minute. No collateral at Lehman. That’s what we call a bank?

    Lehman was funding it’s 30:1 leverage trading in non-collateral by heavy dipping into the 24 hour commercial repo market.

    When people started realizing that their 1% money market funds are being used this way, the money markets froze up. Came as a shock to me too. I never knew I owned a 1% yield hedge fund! So now the USG guarantees them. Problem solved.

  • Posted by Fullcarry

    You might want to remove Dr. Hamilton from the list most concerned about deflation:

  • Posted by Cedric Regula

    Anyone who thinks inflation will fix the economy is smoking something.

    We tried inflation in the ’70s, and the only good things about the ’70s was the music, the parties, mini skirts, and being too young to have to worry about working for a living.

    I also get the sense that inflation advocates think any kind of inflation is good inflation, and also that food and energy inflation is a sort that we shouldn’t worry about(unless they go down, which causes the Fed to scream DEFLATION and crank up the printing press).

    Rising input costs in a weak pricing environment causes margin pressure. The DOW was 600 in the ’70s.

    Inflation eats into consumer discretionary income.

    If you have a fixed rate mortgage, your cost is fixed. If we re-ignite inflation expectations, interest rates on everything will go up, including the public debt, which is now mostly short term debt.

  • Posted by cmc313

    Dear esteemed colleagues:
    It seems to me inflation is the “least” painful way to solve our debt problem since our debts are priced in the dollar. Think of this example — the central bank doubles the money supply in a closed economic system. This should drive price levels, wages, etc. up 100%, but the debt remains unchanged. So creditors gets burned while debtors win. So the US can get away with impunity if ECB also starts QE as all major currencies should then hold relative value vs. each other.
    Regarding deflation vs inflation in the near term, does anyone here know what happened in the late 40s and early 50s when the Fed eventually refused to buy Treasury at fixed low rates? Wonder what happened to GDP and inflation after the Truman accord was put into practice. I think there is a parallel here — at some point the Fed will need to withdraw liquidity by issuing notes. But then who in the right mind would want to buy 10 yr treasury bonds at sub-3% yield? Bond vigilente should then demand very high long rates as US deficits will remain substantial for a long time. How will Treasury finance our deficit at that time? In short, how will the Fed gracefully withdraw liquidity without tanking the treasury?

  • Posted by curious

    i don’t think it’s good to inflate our way out of the problem.

    alot of seniors have some savings left, they’ve already be burned on the 401K, to wipe out cash holdings would be immoral.

    not everyone has the talents as some on this board to hedge themselves through the in’s and out’s of hyperinflation……

    remember we live in a country where more people know the name Brad Pitt vs. how many states are in our nation.

  • Posted by yoda

    “how will the Fed gracefully withdraw liquidity without tanking the treasury?”

    well, it will tank Treasuy. ok, no show to see, move along.

  • Posted by Indian Investor

    It’s been nice to see a textbook bear market coming alive in real life. The equity market hit its speedbreaker pattern, forming dead cat bounces and all. People got bolder and didn’t subscribe as much to the Treasury Bonds, the bond market was ruptured. The Treasury/Fed establishment got concerned and did a massive retaliation on the king financiers with Central Bank monetization. Now the king financiers are running scared, not willing to crash the bond prices anymore. Because of the monetization, gold prices should go up for some more time. Then the textbook says all will be quiet. Government bond prices stop rising, the gold prices stabilize and a steady improvement in equity indices should ensue.
    The only alarm bells I hear are from the black swan postulation that China will change their Treasuries for Euros massively.I can clearly see China is bound with golden chains to peg RMB to the dollar, till such time they’re confident about the domestic market jobs to replace the US export sector.
    I’m not sure exactly how they can balance structural bearishness on the dollar with the employment compulsions and what the full impact of strengthening EUR against USD is. This point is worth thinking about,it shouldn’t matter if the dollar weakens but imports of neccessities like crude and commodities should be sustainable in the medium term for the US economy to recover.

  • Posted by DJC

    Wu Xiaoling, deputy governor of the central bank and former chief of the State Administration of Foreign Exchanges (SAFE), “The best way to minimize [further] risk is to scale down the size of the foreign currency reserves.” According to Wu, other ways the government can reduce the heavy burden of the reserves is by “setting up a [yuan] equity investment fund, or expanding trade and foreign investment”.

    One sector for development clearly targeted by Beijing’s diversification campaign is its strategic petroleum reserves (SPR). As early as January 2009, Zhang Guobao, head of the NEA and vice-minister of the National Development Reform Commission, wrote an article in the People’s Daily saying, “The country [China] should take advantage of falling global energy prices to increase its oil reserves”.

    In a national energy conference in early February, the NEA also announced that China will build eight new strategic SPR bases on top of the current four by 2011, and increase China’s strategic crude capacity to 281 million barrels from 103 million.

  • Posted by gillies

    cedric regula : “The DOW was 600 in the ’70s.”

    what were you smoking ? i seem to remember the dow at 150. maybe there is, somewhere, a googlable chart ? ?