The Fed Can Do That?

By Jeff Harding.

I have been reporting on the Treasury auctions recently and I said that I was surprised that the auctions went so well considering how much new debt they had to finance. I knew they were gaming the market by buying Treasuries on the open market in an attempt to reinforce the market. In early August I reported on economic indicators and said the Fed was monetizing the debt by buying back Treasuries recently sold at auction from the primary dealers who just bought them. It’s another way to support a weak market.

But I confess I was surprised by the good reception the market gave to the auction last week and especially the fact that it was well received by foreign buyers. Commentators were pointing to low inflation expectations and a run up in equities to be the cause. Now I find out there is another reason, actually two reasons.

First I missed a recent very important data point (Mish didn’t):

The market for Treasury bonds is now more reliant on U.S. buyers – including the Federal Reserve after its recent buying spree – than the Chinese.

China held $801.5 billion in Treasury debt at the end of May. The Fed at that time held about $598 billion, although that has now risen to $704 billion. The latest figures for U.S. households, from the first quarter, showed holdings of $643.9 billion – more than double the $266.6 billion in the fourth quarter of 2008.

The rising budget deficit, which has led to record issuance in recent months, doesn’t necessarily mean the government is becoming more indebted to foreigners. While the U.S. government is borrowing furiously, the current account deficit has actually halved from an annualized $829 billion in mid-2005 to an annualized $409.5 billion in the first quarter of 2009. That shows the U.S. is now less dependent on external financing, because it is saving more domestically. The U.S. government may be in hock, but it is increasingly to its own citizens. [But, so did the Japanese during the lost decade.]

China’s monthly purchases of Treasury bonds have actually picked up since 2008, but by much less than the government has expanded sales of bonds.

And U.S. households stepped in to purchase 86% of all new Treasury issues in the first quarter, according to flow-of-funds data. The next snapshot of household appetite will come in September.

Since the first quarter risk appetite has picked up. But Treasurys still account for only 1% of total household assets. Although that is the highest since 2001, Treasurys regularly made up 5% of assets in the 1950s, and as recently as 1995 they were at 2.6% of assets.

History suggests there is plenty of room for households to increase their holdings.

This fits well into my thesis that Americans will continue to increase savings.

The second reason for the smooth auctions is because the Fed has been gaming the market in a different way than just buying back Treasurys. They apparently have been buying agency paper held by foreign central banks which frees up cash by these central banks to buy more Treasurys. And they’ve been hiding the fact that they have been doing this. How do I know? Not by any brilliant analysis by me, but another original bit of research by Chris Martenson. His points:

• Demand for US assets is in negative territory for 2009.
• The Federal Reserve has effectively been monetizing US government debt by cleverly enabling foreign central banks to swap their Agency debt for Treasury debt.
• The shell game that the Fed is currently playing obscures the fact that money is being printed out of thin air and used to buy US government debt.

Here’s how it works:

Analysts can spot how much U.S. assets foreign buyers purchase by a Fed report called Treasury International Capital (TIC) flows. This report showed that there has been a capital outflow of $314 billion, after sales of our debt and purchases of our debt are netted (central banks purchased $50 billion, private investor dispositions were $364 billion). So we know that only $50 billion new central bank capital came in.

Yet during the period Martenson measures, foreign central banks bought about $500 of Treasurys.

What these central banks do when they buy U.S. assets is do it through a kind of brokerage account operated by the Fed, the Federal Reserve Custody Account, which totals about $2.787 trillion. This account keeps growing. It has increased by $431.4 billion the past 12 months and by more than $275 billion in 2009 (through July 29), yet we know that only $50 billion came in from central banks this year.

Where did the cash come from? Martenson does some simply arithmetic:

Courtesy www.chrismartenson.com

The $135.3 million is growth in the account through interest paid on assets. So where did the rest of the money come from to buy Treasuries? It appears that the Fed has been buying agency debt directly from these central banks which frees up cash to allow them to buy more Treasurys than they otherwise could. They have an interest in keeping the Treasury markets stable.

This chart shows that agency debt has been shrinking and Treasurys have been increasing in the Custody account.

Courtesy www.chrismartenson.com

Brilliant research. But what does it all mean? If Martenson is correct on this, then:

1. The Fed is more worried than we thought about financing the deficit and they need to resort to a variety of tricks to ensure stable auctions. A crack in the wall could spell disaster for the dollar and drive up interest rates. Now that people are aware of this …

2. The Fed is monetizing more of this debt than we thought. Monetizing debt is when a central bank buys their own government’s debt. It is another way to print money. By buying agency debt which allows central banks to buy more Treasury paper is just a clever way to monetize the Treasury debt.

3. It doesn’t look good for the dollar in the long term. Long term inflationary pressures will eventually impact the markets as credit markets ultimately restore themselves to normal. No one can predict when this will occur. It won’t happen as long as consumers restrict spending and increase savings.

4. In the near(er) term there are reasons the dollar won’t tank:

Neither China nor Japan want to see the dollar tank and I believe they will continue to support the dollar and buy our debt. They really don’t have much of a choice since they hold so much of it.

A declining dollar will make imports more expensive, but it also will make our exports cheaper for foreign markets which is not something foreign holders of dollars necessarily want to see.

We are still in a deflationary spiral as real estate continues to tank and consumer debt is being paid down.

We are net importing far less now during this recession which means there will be fewer dollars accumulating abroad. But that could change depending on what happens to oil. Right now oil is settling down again as economies shrink. But, another international crisis could change all that.

It still appears that the dollar is the go-to currency in a crisis, as this recession has shown. In November, 2008, when the markets panicked buyers rushed into Treasuries.

If the Fed isn’t supposed to buy Treasury debt at auction, how can they do this? Another reason to support Ron Paul’s bill requiring an audit of the Fed.