Friday, February 08, 2013

Treasury Using Fed to Create Illusion of US Bond Market

The Treasury Department, in conjunction with the Federal Reserve, has created its own bond market.

The government's monthly borrowing needs are so great that it can't find enough corporate, institutional and sovereign buyers on the open market to purchase the copious amounts of available U.S. debt.

Consequently, the Federal Reserve's printing press has become the alternative.

The U.S. private sector — namely banks, mutual funds, corporations and individuals — reduced purchases of U.S. government debt to a meager 0.9 percent of GDP in 2011, from a peak of more than 6 percent in 2009. That's because everyone is chasing higher yields in riskier markets.

This has put the U.S. in desperate situation where it has sought a buyer of last resort. Enter the Fed.

The U.S. is heavily reliant on short-term funding; only 10 percent of the public debt matures beyond ten years. This creates constant pressure to issue new debt and to get our creditors to roll over their existing debt, with the promise of even more interest payments down the road.

This is an important concept: the federal government — already so deeply in debt — must continue issuing Treasuries just to pay back its current debt holders, in addition to maintaining its deficit spending.

This means the U.S. is on a never-ending carousel of debt. The government has to continue issuing new debts just to support its old debts.

Like any pyramid or Ponzi scheme, the system needs continuous inflows of new money to refinance its debts and keep itself afloat.

The U.S. economy has become so reliant on these Fed purchases, that it's reasonable to wonder if — not when — they will end. Simply put, the U.S. government would cease to function without the absolutely massive interventions of its central bank.

This month, the Fed will buy 75% of new 30-year Treasuries. While that sounds utterly astonishing, such an outsized share is reflective of the increasing surge that has been taking place over the last few years.

In 2011, the Federal Reserve purchased a stunning 61 percent of the total net Treasury issuance. And the Fed has purchased 41% of all the 30-year Treasury bonds issued since 2009.

The Fed is effectively subsidizing the U.S. government's borrowing and spending. It allows the government to repay older, maturing debt that is not rolled over and reinvested by legitimate creditors.

Given that the U.S. is piling ever more debt onto its current $16.4 trillion burden, it's understandable that foreign governments and sovereign wealth funds may feel reluctant — or even refuse — to roll over their existing debts.

In essence, the Fed is monetizing U.S. debt, meaning that it is printing money — backed by nothing — so that the government can maintain its deficit spending and debt payments.

Monetizing the debt will devalue the dollar and eventually spike inflation. That would create a self-perpetuating cycle in which inflation then decreases the buying power of the dollar.

When interest rates eventually rise (and they will), there will be a variety of consequences. Rising interest rates automatically devalue older bonds issued at lower fixed rates. That will be punishing to holders of current Treasuries.

Right now, yields are barely keeping up with inflation and are, in fact, usually losing bets. Last year, inflation ran at 2.1 percent. Meanwhile, the yield on 10-year notes was 1.78 percent at the end of 2012, while the yield on the 5-year note was 0.72 percent.

Famed investor Jim Rogers says he is short long-term government bonds. A short position is a bet that the value of an asset will decline.

With the U.S. dollar used as the world's reserve currency and U.S. Treasuries historically viewed as the safest of all investments, the Fed has long been able to control interest rates.

But if investors demand higher rates due to reckless U.S. fiscal and monetary polices, the general consensus is that the Fed will then lose its control over rates, which would subsequently begin to rise.

However, if the Treasury can continue using the Fed to create an artificial debt market, then it should be able to keep interest rates at paltry levels — at least as long as it is able to maintain this charade.

How long will that be? Who knows?

Everything can seem to be going along just fine, until suddenly it isn't.

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