It Works Until It Doesn’t

Back in 2008-9, when it seemed that the world was about to implode, I wrote this article about how odd it was that JP Morgan Chase stepped in and bought an entire bond issue from the State of Illinois, at a time when no one else was interested in our debt.

The US government has been buying its own debt for some time now. The WSJ today had an article entitled “Treasurys Face Tougher Path” that sums up our dilemma:

“If we remove the Fed’s purchasing and remove the trillions in Treasurys they hold, what would be the true market value of Treasurys?… I think we would certainly have failed auctions at the current interest rates if the Fed was not the majority purchaser”

A different article in today’s WSJ called “EU Banks Stashing Cash for Safety” reported that European banks were “parking” their money with central banks rather than lend out to customers, purchase securities (like bonds, above), or loan it to one another.

The 8 giant European banks that have disclosed their annual results in recent weeks reported holding a total of about $816 billion in cash and deposits at central banks as of Dec 31… that is up 50% from a year earlier… The stockpiling… represented a collective response to the growing pressures on the European Financial system. By storing funds at central banks in Europe, the US, and elsewhere, banks assure that their money is safe.

As the article above states, we don’t know what the price of debt would be if the US government wasn’t purchasing a substantial portion of the total issuance. It likely would be higher. And in Europe, with losses looming on Greek debt, banks are now questioning their position in the debt markets and apparently “parking” their money more and more rather than purchasing government debt issues.

In the US we take for granted that we can keep issuing debt to fund our ballooning deficit and that we can find willing buyers at miniscule interest rates. We are also putting our hand on the scale by buying back a lot of the securities that we are auctioning off (try explaining that one to someone who isn’t sophisticated in finance). Like everything else, this works until it doesn’t, and with banks and the US government not buying bonds in the same quantities, who IS going to want to load up on Treasurys at these rates?

In parallel, the stock market is returning more than ever when dividends are taken into account. There never has been a time in recent history where stocks (assuming dividends and share buy-backs) are returning such a high premium over debt. Thus why would individuals want to purchase Treasurys when (cash) returns in stocks are so much higher?

It will be interesting to see how this all plays out. My guess is that it will end badly.

9 thoughts on “It Works Until It Doesn’t”

  1. The moment your currency loses it’s status as the currency of record you are doomed. It’s only because Helicopter Ben keeps goosing the stock market with treasury manipulation that it has achieved the level it has. Pretty well entirely illusory as it sits.

    This is just what’s on top. There is also a massive amount of bad debt that is not “marked to market” since that rule was quashed. It is very large, that’s about all we really know. Many of the supposedly stable institutions are really rotten maggot filled disasters waiting to be exposed.

    CDS. Oh yeah. Lets just imagine Greece failing and defaulting on it’s debt. The best thing they could do for their people BTW. There is so much hedged with Credit Default Swaps that the carnage among the hedge funds would be epic. It would largely destroy the economy of the USA.

    Uh huh. Interesting times indeed.

  2. It’s probably a matter of time before something gives, the govt bond mkt tanks, and the cost of financing our public debt explodes, triggering a financial crisis. Not likely before the election but who knows. This kind of market distortion tends to last much longer than anyone expects, before ending suddenly.

  3. Yes watching the drama unfold in Europe makes me cringe because it could happen here anytime without warning.

    You either have confidence or you don’t.

    In any case the fact that we have been buying a substantial portion of our own debt auctions makes it a double leveraged bet.

  4. What is the best way to describe this? A “deficit bubble?” This won’t end badly, it will end catastrophically.

  5. We may muddle through. It looks like Europe may be muddling through as weaker countries are set adrift and stronger countries reform and regroup. In the USA we could have moderate growth and moderate inflation for a while. I say this because if you expect things to fall apart and they don’t, then maybe something else is going on. Some of the alternative scenarios aren’t so bad. Time will tell. I would be more pessimistic if there weren’t already so much pessimism in the air.

    Also, we are looking through a frame in which crisis = bad. But it may be that a financial crisis will be necessary to create the political consensus for necessary reforms. Perhaps that is happening in Europe.

  6. a financial crisis will be necessary to create the political consensus for necessary reforms.

    Bingo. No matter how bad it gets, any financial crisis will be preferable to a 21st century world war.

  7. The US government has been buying its own debt for some time now.

    How is this legal?
    How can this possibly succeed?
    How can I do this?

    a financial crisis will be necessary to create the political consensus for necessary reforms.

    Never let a crisis go to waste. Any more “reform” of the Constitution and the USA might as well ask the EU for status as a Gau or SSR.

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