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US funding capability - no alarms...yet
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The week of November 9th is going to be a good indication of confidence in the US government. It is the quarterly round of funding in which $81 billion of bonds are auctioned. Considering the large budget deficits and speculation of future inflation, interest rates have remained relatively low. Interest rates typically increase as financial stability decreases and inflation increases.
Monday, the Treasury Department issued $40 billion of 3-year Treasuries. Results far surpassed expectations. Preliminary pricing put the interest rate at 1.422%. A large demand for the bonds drove the yield down to 1.404% at final issuance. The Treasury received bids totaling $133 billion, a 3.33 ratio of bids to the total bond offering. This is highest ratio on 3-year Treasuries in 19 years.
Foreign investors were a part of the auction as well. Japan and China remained two of the top foreign central banks participating. As mentioned in the previous article 'Does the buck stop here', it is speculated these countries are losing interest in holding the dollar. As the dollar has depreciated over 15% over the last year and receiving between 1-2% of Treasury holdings, foreign investors have a net loss of 13-14% relative to holding their own currency.
The participation rates in Monday's auction all points to the positive, but this only covers half of the week's activities. The Treasury is set to sell $25 billion in 10-year notes on Tuesday and $16 billion in 30-year notes on Thursday. These will provide a good indicator of the willingness to hold the US dollar long-term.
Bond markets, as with all financial markets, are all relative to the next best alternative. In the years prior to the financial crisis, investors had the option to invest in US Treasuries, US Agency bonds (issued by government agencies such as Fannie Mae & Freddie Mac), and mortgage backed securities (MBS). These alternatives created competition for the US Treasuries.
Today, the US Federal Reserve (Fed) has eliminated the competition in the US Agency bonds and MBS issuances. In fact, the Fed has purchased nearly $900 billion of the $1.1 trillion issued across these markets since June 2008; 80% of the total.
The elimination of this option has forced foreign governments who do have demand for US bonds to remain with Treasuries. Foreign buying in Treasuries is up a healthy $350 billion from June 2008 to June 2009 from the same time frame in 2007-2008 while investment in MBS and US Agency debt, down $375 billion. A further split would show that foreign buying of short-term Treasuries similar to Monday's auction is up $325 billion. Compare that to a minimal increase of $25 billion increase in longer-term Treasuries.
The steepening of the yield curve over the past year reflects this trend (see graph). Investors are demanding increasing rates for holding the US dollar for longer periods of time. As the Fed continues to print money, at risk of inflation, and over 60% of US debt coming due in the next 36 months, the "we'll worry about it when the recession ends" strategy may not remain viable.
To put it in perspective, in order to cover the debt coming due the US savings rate, negative and below 1% just months ago is already increased to 6%. This would need to double to 12%. Purchases of Treasuries by commercial banks would need to increase to $400 billion, who we all know are currently under the Fed's safety net. Both would be near historic highs and seem quite unlikely.
Demand will certainly outstrip the remaining $41 billion of Treasury note offerings this week, as it always does. We can be sure the bid to amount offered ratio won't rival the shorter term notes offered Monday. It definitely won't be a huge surprise if the yield curve continues to steepen.
The current motto of the Treasury might as well be, "We're lucky the grass isn't greener on the other side."
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