Choking on Debt

From Reuters:

NEW YORK, March 25 (Reuters) - U.S. Treasuries fell on Wednesday, with benchmark yields reaching their highest levels in a week on concerns over a surge of debt supply to finance the ballooning U.S. deficit.

Losses extended on Wednesday afternoon after tepid demand in a record-large auction of five-year Treasury notes fueled fears that investors may not have sufficient appetite to swallow all of the new supply.

The drop in prices was limited, however, by the Federal Reserve's debut purchase of government bonds, which is intended to boost government debt prices and sink yields.

Translation: Periodically, the Treasury holds debt auctions, selling Treasury debt certificates to raise money. There are two contributing sources: new bonds issued to fund deficit spending, and new bonds issued to pay for the retirement of old bonds which have matured (debt "rollover"). Debt rollover is necessary because the government doesn't have enough money to simply pay off any of its debts which have "come due" (i.e. it is running a deficit). So, even though the government is expected to run a ~$2 trillion deficit this year, it will have to auction probably ~$5 trillion this year, or possibly more. One of those auctions was held today, and buyers "choked," at least a bit. More supply than demand, but it could have been worse. There simply weren't that many buyers willing to pay for the debt certificates that the Treasury was selling. So the Treasury had to offer a higher coupon (more interest) to keep people buying. In addition, the FED intervened (as Bernanke had said it would), buying up some of the debt (about ~$7 billion worth) with newly printed money. This, of course, is inflation. That $7 billion will show up in the AMB as fresh money entering the monetary base, and the Treasuries will show up on the FED's balance sheet. Where will the new money go? To the Treasury, where it will be spent, buying whatever it is the government is buying (warplanes, bridges, bureaucrat salaries, etc.). It will enter a bank account when the government check gets deposited. From there, there are two possibilities. It could get deposited back with the FED as excess reserves, which is what banks have been doing with their money lately, or it could be lent out, beginning the process of multiplication by the fractional reserve banking system, getting multiplied up to ~10-fold in the process. That's right. This money could wind up as a ~$70 billion increase in the more comprehensive money aggregates (M1, M2, etc.) For this reason, this stuff is called "high-powered money." So, what's the significance? Each time the FED makes these purchases, it suppressed the interest rate for government borrowing in the short term, at the expense of inflation and consequently higher interest rates in the long term. Furthermore, the government is in effect "buying" the private sector. Each purchase diverts resources away from the private sector, increasing costs for private businesses competing for those resources and inhibiting their ability to grow and make the adjustments necessary to return to profitability. This does not escape the notice of savvy investors. It should not escape yours. Watch these auctions. If the dollar dies, it is likely to be in connection to one of them. If rates rise, it's a reflection that the value of the underlying asset (the bond) is losing value. China alone holds ~$1 trillion of these puppies. Supposing rates go from ~3% to ~6%, they are looking at a ~50% loss on longer dated bonds. Don't expect people holding these assets to just sit there and take it. They will sell to cut losses. Rates will rise even further as even more supply comes onto market. Its a vicious cycle. The FED will be forced to intervene. It will print more money to buy the debt, inflating ever further. We have already discussed what that means... But don't think that "they" haven't thought of this. There is talk of yet another tool for FED manipulation.

The U.S. Federal Reserve is considering issuing its own debt for the first time, the Wall Street Journal said, citing people familiar with the matter.

Fed officials have approached Congress about the move, which could include issuing bills or some other form of debt and would provide the central bank with more flexibility to tackle the financial crisis, the Journal said.

This is banana republic stuff. It is called "sterilization." Basically, it is a way to take the newly printed money and bury it in a hole in the ground so that it has no inflationary effect. The FED borrows money, and does nothing with it. It simply takes it off the market. FED buying of Treasury debt increases the money supply. FED borrowing decreases the money supply. Government gets the money, FED avoids inflation. Problem solved, right? Not exactly. The problem with this strategy is that, basically, the FED would be borrowing from the private market in order to lend to Treasury. Which is to say, overall, the Treasury would be borrowing from the private market. At first glance, there is no point... except that the FED would presumably offer a higher interest rate so that it could offer the government a lower rate. The FED takes the interest payment hit, not the government. The government gets to borrow at a lower rate and pretend to be solvent. The FED simply prints the money to pay its interest. The FED never goes insolvent. In addition, the borrowing activity of the FED will compete with the borrowing activity of the Treasury, since there are only so many lenders out there. It's simple conservation of matter. The FED is simply adding another layer to the debt cake. It is not solving the problem. As the FED pays out interest, the inflation is spread out over time. There will be less of a "stimulative effect" now (which seems to defeat the whole purpose of all this, actually), and a longer time frame for the inflation. But it will still be inflation. This is typical Washington kick-the-can-down-the-road strategy. Nothing new, just more convolution. There simply must be inflation. This is the only tool the government has to make the books balance, at least in nominal (and legal) terms. No matter how they slice and dice it, no matter how it gets relabeled, that is what it is. It is either inflation, or default for an awful lot of people. Which is to say, it is either dishonest default, or default. There is no alternative. However, depending on exactly where rates end up, the nominal price of Treasury debt certificates will be held up by the interest rate suppression, while the FED will be paying out enormous interest to its lenders. So Treasury certificate holders (China) will be more protected, while those who are forced to pay their taxes and do all their business in US dollars (Americans) will be more devastated. Of course, the exact degree of each will be completely under the control of the politicians in Washington. Which I suppose was the point all along. More shuck-and-jive, eh Ben?