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The Cycle of Fortune Invades a Confederacy of Dunces


It's hard to say which group is more stubborn, politicians or the Fed.


With the breakdown of the Medieval system, the gods of Chaos, Lunacy, and Bad Taste gained ascendancy.
– Ignatius Reilly, A Confederacy of Dunces by John Kennedy Toole

This past week Chairman Bernanke gave his bi-annual Humphrey Hawkins testimony in front of Congress. Whenever the Chairman goes in front of legislators who, by and large have no economics background, we are usually left with some colorful exchanges. This week was no exception. New York Senator Charles Schumer probably caught the most headlines. Schumer goes through the list of fiscal failures and then addresses the monetary policy responses of QE and the options in the toolkit. Not exuding a lot of confidence Bernanke assures him there are options left. Schumer then confidently urged Bernanke to "Get to work, Mr. Chairman."

The exchange with Senator Schumer epitomized the tragic political reality known as the US government. Not only is there no will to do what is necessary, there is no concept of what is necessary to do. Some elected officials appear mired in a debate not about what will happen in the future but of what we already know about what already happened in the past. They are like Keystone Cops running around bumping into each other proclaiming that each previous failed policy of supply-side tax cuts vs. Keynesian spending is the least destructive path to fiscal insolvency.

The same can be said for the Federal Reserve. They employ tools that proved ineffective in the past only to see them ineffective in the future. In the race to the bottom the Fed is merely trying to find the least destructive path to monetary insolvency. It truly is the definition of insanity.

This November the election will be framed by a simple choice of who you believe has the best prescription to fix the short term US economic crisis. But the more vital decision is who you believe will fix the long term US fiscal crisis which is far more important for the future of this country. Sceptics have said that both parties will claim they have the solutions to cure both pending catastrophes but thus far neither has proven to have the spine to do what is necessary. They couldn't even get Simpson Bowles passed, and that may not even be enough. In fact, absent some radical changes and draconian measures that include slashing the federal government entitlements while also raising taxes it may very well already be too late. When this Treasury market turns we are in a serious situation that could death spiral before Washington even knows what happened.

The US debt is broken down into two segments, debt held by the public (US Treasury market stock) and intra-government holdings (entitlement liabilities). As much as the explosive yet non-booked entitlement liabilities are weighing on our future, it has been the debt held by the public or supply of marketable securities that has exploded since 2008.

The numbers are staggering. In the years 2008-2010 the US Treasury stock year-over-year increase was 24.3%, 22.78% and 20.3% with the 2011 growth rate slowing to a still rapid 11.4% rate. To put this debt explosion in historical context, in the preceding 45 years only once did the YOY growth rate exceed 20% and that was in 1975.

On Monday Bloomberg ran a story titled Treasuries Doomsday Is Four Years Away for Vanguard quoting Robert Auwaerter, the fund group's head of fixed income. Vanguard is the largest private holder of US Treasuries with $148.2b. The article references something my firm views as very important in the reserve currency status of the US dollar currently comprising 62% of all currency reserves. Auwaerter says, "The US Treasury gets a pass, in part because the liquidity in that market brings buyers in that would maybe not be there if there was a viable alternative."

The bullish case for Treasuries is predicated on the debt deflation views and there has been no stronger bull than Dr. Lacy Hunt of Hoisington Investment Management. I was sent a copy of his Second Quarter Review and Outlook and thought it summed up the bullish case quite well. Pointing past cycles of over indebtedness and deleveraging that produced long periods of low interest rates that follow Hunt concludes that US Treasury duration is a "desirable asset to hold."

Citing US debt buildup to finance the railroads in the 1860 and 1870s, the debt buildup preceding the Great Depression and the Japanese deflationary period beginning in 1989 Hunt builds the case:
In the aftermath of all these debt-induced panics, long-term Treasury bond yields declined, respectively, from 3.5%, 3.6% and 5.5 % to the extremely low levels of 2% or less in all three cases.

Amazingly, twenty years after each of these panic years, long-term yields were still very depressed, with the average yield of just 2.5%. Thus, all these episodes, including Japan's, produced highly similar and long lasting interest rate patterns.

The relevant point to take from this analysis is that US economic conditions beginning in 2008 were caused by the same conditions that existed in these above mentioned panic years. Therefore, history suggests that over-indebtedness and its resultant slowing of economic activity supports the proposition that a prolonged move to very depressed levels of long-term government yields is probable.

If high indebtedness is indeed the main determinant of future economic growth and further government "stimulus" is counterproductive, then a prolonged state of debt induced coma may so limit returns on other riskier assets that a 30-year Treasury bond with a 2% yield would be a highly desirable asset to hold.

Hunt isn't just long the Treasury market, he's really long with nearly half of his position in long duration zeros and his performance has been stellar. His 12 month return is 44.4% net of fees and 20 year annual return is 10% vs. the Barclays index with returns of 7.5% and 6.5% respectively.

The question is not whether interest rates get to the historic levels we've already reached; the question is whether we will stay here for a long period of time. I don't disagree with the economic assessment Hunt is making, but there is difference between economics and market dynamics.

Since trading railroad bonds in 1870 is probably a bit different that today's massive US Treasury market, I think it's a bit dangerous to compare the periods, so for argument's sake, let's compare today with Japan's still-two-decade-long period of record low bond yields.

There is one major difference between the periods Hunt cites and the current US period of over-indebtedness deleveraging. None of those periods involved debt issued in the world's reserve currency. As we discussed in The US Dollar's Triffin Dilemma Adjustment Disorder owning the reserve currency is a great benefit for the issuing debtor, but eventually it turns into a curse.

Unlike Japan, which internally finances their debt, the US largely externally finances its debt. The foreign ownership has grown just as dramatically as the total debt over the past four decades. According to a report in the Financial Times, this past March foreign holdings of Japanese government bonds (JGBs) hit a record level at 8.3% of total $11.5t. Contrast that with foreign holders of US Treasuries (USTs) which at last count in May stood at 50% of total $10.5t debt outstanding.

The top holders of USTs in this order are the Federal Reserve, China and Japan at $1.65t, $1.17t and $1.1t respectively with OPEC countries coming in a distant fourth at $260b. In fact Japan's holdings alone represent 10.5% of USTs outstanding which is a larger percentage of total foreign ownership of JGBs. Why is this important?

We went through the Fed's Flow of Funds data to breakdown the total debt growth and percentage owned by foreigners. This bull market in foreign ownership could be another great example of the reflexive process in the bond market. The lower yields go, the more we borrow and the larger the percent owned by foreigner holders. But is there a limit? Are these bull markets connected by the Triffin Dilemma and reflexivity?

In 1970 foreigners owned 6% of the stock of treasuries but the following year, probably due to Nixon shutting the gold window, that number jumped by 135% YOY to 14% of the outstanding stock. That 15% area stayed pretty constant even as the debt outstanding increased by 185% in eight years under the Reagan administration.

When Bill Clinton took office in 1993 Treasury debt outstanding stood at $3.309t and when he left in 2001 that number was only 1.4% higher at $3.352t. Clinton didn't increase the debt, but as foreigners continued to buy, the foreign ownership increased dramatically in those eight years from 17% when he took office to 30% when he left.

Under George W. Bush the numbers continue to climb and start to get scary as the debt level increases again. Foreigners further increased their exposure to 51% owning $3.25t in 2008 roughly the amount of total debt outstanding of $3.3t when he took office in 2001.

As we stated above the Obama Administration has literally blown the roof off the debt ceiling, increasing the stock by over $1t per year, and foreigners kept up the pace. Today foreigners own $5.264t which is more than the total debt outstanding only five years ago in 2007 when it was $5.099t.

Now here is where it gets interesting. Consider in 2011 interest expense on debt outstanding was $454b and the US increased borrowing by $1.067t. Foreigners kept their 50% allocation buying $561b with China a net seller of $8.2b and Japan a buyer of $175.7b. The largest holder, the Federal Reserve bought $766.5b representing 72% of the increase in supply. Combine the Fed and foreign buyers and they bought the equivalent of 125% of the increase in Treasury stock and thus pushed the 10YR from 3.35% to 1.90%.

What is holding interest rates down? Is it a liquidity trap, lack demand for money, slow economic activity, or debt deleveraging? That would imply the domestic private sector is buying and in 2011 they were nowhere to be found. In 2009 and 2010 the non-financial and household sectors substantially increased their holdings of Treasuries from just over $100b in 2008 to $1.1t in 2010, but that number has stayed relatively stable since then at 1.168t last quarter. Their total securities holdings have been pretty steady since 2006 at $18-$19t so for them to increase their Treasury holdings from here, that money would have to come from another asset. That seems to be a stretch at negative yields.

Here's the dirty little secret. Bernanke says the Fed believes in the stock argument which says the stock of Treasuries the Fed owns on their balance sheet is holding rates down. If that's the case and the 10YR is at a record low at the end of June, why did they extend Operation Twist? If it's the stock that mattered and not the flow then there would be no reason to extend the program, they would just keep the balance sheet at $2.6t.

The fact is there are only two buyers and one is out of bullets when Operation Twist ends in December. The only way the Fed can keep a lid on rates is another round of QE via turning the printing press back on. If they print, the dollar will weaken, possibly substantially as an inflationary death spiral ensues due to printing money to finance interest expense. Then your other buyer will suddenly see no end in sight as that buyer's future value of total holdings substantially erodes. It would be a direct slap in the face and a dangerous game to blatantly devalue the principal and coupon of your 50% holder. And the Fed knows this.

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.

So the Fed faces a "damned if you do, damned if you don't" decision. Don't print and remove yourself, the primary buyer. Print and run the risk of alienating the only other buyer. We aren't saying the bullish case for Treasuries is misplaced, but there is a difference in the analogy due to the reserve currency status and externally financed debt. The Fed has created a high false sense of demand in the market and it has its limits. Replacing that demand may be difficult for the market to stomach.

Chapter 2 A Confederacy of Dunces by John Kennedy Toole:

Ignatius pulled his flannel nightshirt up and looked at his bloated stomach. He often bloated while lying in bed in the morning contemplating the unfortunate turn that events had taken since the Reformation. Doris Day and Greyhound Scenicruisers, whenever they came to mind, created an even more rapid expansion of his central region. But since the attempted arrest and the accident, he had been bloating for almost no reason at all, his pyloric valve snapping shut indiscriminately and filling his stomach with trapped gas, gas which had character and being and resented its confinement. He wondered whether his pyloric valve might be trying, Cassandralike, to tell him something. As a medievalist Ignatius believed in the rota Fortunae, or wheel of fortune, a central concept in De Consolatione Philosophiae... Boethius, the late Roman who had written the Consolatione while unjustly imprisoned by the emperor, had said that a blind goddess spins us on a wheel, that our luck comes in cycles. Was this ludicrous attempt to arrest him the beginning of a bad cycle?

When you watch Bernanke in front of Congress you'll notice he exhibits the expression of one with extreme discomfort in his central region. Perhaps his valve might be trying to tell him something. That the cycle of good fortune enjoyed by issuing debt in the reserve currency might be turning into a cycle of doom.

Twitter: @exantefactor
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