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The Bond Market's China Syndrome


We are blaming Europe for our current economic problems, but in reality they are doing us a favor by providing a blueprint for how a bond market meltdown can unfold.


Thus far the ex ante analysis has been on target as the scenario has been playing out according to plan. We got our new highs in bonds (all-time) on stock market weakness and it appears to be prompting more Fed action. Then on Friday I got what I've been waiting for since April (as reported by Sedacca). The CFTC commitment of traders report showed that for the first time since we noted this potential squeeze in April large specs were finally net long. The question for investors is whether this sets up for a market top and intense reversal.

The COT report survey ends on the prior Tuesday so it's probably not a coincidence that specs covered to get long in front of Wednesday's FOMC meeting potentially expecting some sort of action forthcoming, and "they" are not alone. Wednesday's Stone & McCarthy money manager survey showed that real money investors are the longest against their benchmark they've been since November 2010 when the Fed launched QE II. Then on Thursday CRT's Ian Lyngen reported his Nonfarm Payroll Survey found investors to be very BULLISH.

From a Reuters MacroScope blog post:

Despite the vacation season and the multitude of 'out of office' responses we got, participation in this month's survey was above-average and consistent with a market that's engaged for the big policy/data events of the summer. As for the results of the survey, in a word: BULLISH.

In a post-non-farm payrolls rally, we found 23 percent of respondents willing to chase a rally - much higher than the 10 percent average and the highest since April 2012. Very few participants were willing to sell strength: just 19 percent versus a 40 percent average, the lowest on record.

Wow. No one wants to let them go because they think the Fed's going to come get them. But will the Fed buy them all? They might have to. I don't dispute that QE III is coming in fact as I stated last week that the nuclear option is on the table (see Bernanke's Astonishingly Good Idea):
If the Fed did go nuts and drop money from the skies they would be naive if they thought it would not elicit a severe market response. The inflationary tail risk would likely manifest itself in an immediate collapse in the US dollar and a corresponding rise in long term interest rates.

In the July 21 issue of Barron's Macro Mavens Stephanie Pomboy pointed to the risk in what she implied would be perpetual QE.
But the Fed is really the only natural buyer of Treasuries anymore. It will have to continue to monetize Treasury issuance at the same time all the other major developed economies-from the Bank of Japan to the Bank of England to the European Central Bank-are doing the same. Pursue that to its natural conclusion, and you see the inevitable demise of fiat money. To look at our policies and not be concerned about the risks to our currency would be dangerously naive.
What she is implying is critical to understanding the risks the Fed faces in printing the world's reserve currency in order to monetize the US Treasury's expanding supply of debt. In fact she exposes the dirty little secret.
The real urgency for QE is not the economic outlook, but that the Fed has made itself the only natural buyer of Treasuries; during QE2 they were 61% of the market. At the peak of the housing bubble and globalization nirvana, foreigners absorbed 82% of Treasury issuance; today, it's 26%.... We have over $1 trillion annually in Treasury issuance, and our foreign creditors are buying $300 billion.

This week the US Treasury announced they would need to increase their borrowing needs above previous forecasts. During the July-September quarter the Treasury expects to issue $276b in marketable debt, $12b higher than announced in April. During the October-December quarter the Treasury expects to issue $316b. So inline with the $1t run rate. But when does this need to continually expand debt outstanding end? With Congress or the fiscal cliff? I don't think so.

The truth of the matter is the federal government could cut discretionary spending to zero and not put a dent in the debt. According to the last GDP report federal spending (ex entitlements and interest) amounted to $1.2t up from $1.0t in 2008. Over the same time frame our Treasury debt has grown from $5.7t to $10.5t.

As mentioned in The Cycle of Fortune Invades a Confederacy of Dunces, foreign holdings as a percent has kept up with rising Treasury supply staying at 50% of outstanding. Because foreign governments largely represent an uneconomic buyer of Treasuries, i.e. one not sensitive to price, they have maintained their allocation as supply expanded. However they now control an amount equal to what our outstanding debt should be. That's a problem.
Today foreigners own $5.264t which is more than the total debt outstanding only five years ago in 2007 when it was $5.099t.

But now at the zero bound with the Fed devaluing the currency to keep it there, presumably there is a point the uneconomic foreigner could become economic.
Would the market inflict no consequence of this most egregious inflationary policy at the lowest coupons in history? Foreign holders have ridden a historic bull market to negative yields. Will they continue to increase exposure at the zero bound? Maybe, but unlike the Japanese internal buyers of JGBs who were mired in a deflationary spiral, foreign holders of Treasuries have currency exposure. With virtually no upside left in price and negative yields with the Fed devaluing the currency, they are faced with what would seem to be an inverted risk/reward.

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