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:
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):
In the July 21 issue of Barron’s Macro Mavens Stephanie Pomboy pointed to the risk in what she implied would be perpetual QE.
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.
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.