Here are some rough numbers to give you an idea of the size of the U.S. bond market. These figures come from Merrill Lynch, and they represent the major categories of liquid, investment grade bonds outstanding that are not held by governments or government agencies. Funding one year of the trillion-dollar federal budget deficit will only increase the size of this market by about 8%. That's not insignificant, but it's not enough by itself to cause the value of all $13 trillion worth of bonds to change by any significant amount. All non-Treasury bonds are effectively priced off of Treasury bonds, so if T-bond prices take a nose-dive, then all bonds have to take a similar nose-dive.By the same logic, it should not be too difficult for the Fed to execute its exit strategy if it chose to do so. The Fed currently holds about $620 billion of Agency and MBS securities. If they sold $100 billion of those securities a month that would be similar in order of magnitude terms to the amount of debt that Treasury is selling to fund this year's deficit. And their balance sheet would shrink dramatically, almost as fast as it increased last year.
And despite all the Treasury issuance this year, and despite the difficulties the bond market has had for the past year, and despite all the losses that major institutional investors have suffered, the average price of mortgage-backed securities has not changed materially year to date.
It's a very big bond market out there, and hundreds of billions and even trillions are not that hard for the market to absorb, believe it or not.
The history of the '70's inflation on bonds is interesting. When inflation began to erode P/E's equity holders went to bonds which preserved principal and out-performed equity handily. I think this would be the larger issue should Bernanke not rein in excess dollars. But, if he does as he just promised, then equities will be priced at less than 6% Cap Rate and are nicely undervalued today. If Bernanke tames inflation to less than 2%, then a 5% Cap Rate could provide substantial upside to even this story.
ReplyDeleteNice information.
Here is hoping that the Fed, which did not properly diagnose the severity of the problem in the first place, and who significantly contributed to its creation over the past 25 years, somehow musters up the ability to properly gauge the Global impact of all of this "non conventional" intervention, miraculously extracts liquidity at just the right time.
ReplyDeleteAre you listening to yourselves?
Here is an interesting article claiming that in order for the market to absorb the coming wave of US debt, the current holders would have to triple their purchases from last year which seems highly unlikely considering they are well behind the necessary pace thus far.
ReplyDeleteOn top of that, most of where the Treasury gets its money to spend is from Medicare/Social Security funds which are running dry and stuffed with IOU's.
Not sure why most people think to solve a debt crisis is to pile on new debt but I suppose some do not think we have a debt crisis.
http://sprott.com/Docs/marketsataglance/June_2009.pdf
Public: There are a lot of misconceptions out there about debt and deficit financing. Will it be impossible for the government to sell $2.0 trillion of bonds this year to fund the deficit, considering that is about triple what was sold last year? No. The amazing and overlooked fact is that Treasury has already sold $800 billion so far this year, and bond yields are still way below historic averages.
ReplyDeleteThe numbers that I refer to all include receipts and expenditures for Medicare and SS. Nothing is left out.
No argument about the wisdom of running up huge debts in the hopes of somehow fixing things. It's madness. But it won't kill us anytime soon, unfortunately. The bond vigilantes are not yet overly concerned.
On your last note I sense a hint of agreement between us ;)
ReplyDeleteThe expectation seems to be that households and commercial banks will meaningfully increase their purchases of Treasuries (which are relatively low, historically). David Rosenberg did some good work on this while still at Merrill. If I have time, I will try to dig it out and post some numbers.
ReplyDeleteMW: That makes sense, but that doesn't make it a smart thing to do. The world is still very hungry for safety.
ReplyDeleteI'm curious how Congress will react when the Fed starts selling down 1.25trn of nicely convex Fannie 4s & 4.5s at 80c.
ReplyDelete