A Shortage of United States Government Debt

Updated January 2017

Despite the fact that the United States federal government debt has done these two things since the beginning of the Great Recession:

...a recent piece by Narayan Kocherlakota, former President of the Federal Reserve Bank of Minneapolis between 2009 and 2015 and current professor of Economics at the University of Rochester, suggests that there simply isn't enough U.S. debt to satisfy the world's insatiable thirst for United States-denominated paper money in the form of Treasury bonds, notes, bills and Treasury Inflation-Protected Securities or TIPS.

As you may have noted in the first graph, the federally-sourced public debt has risen from $9.221 trillion on January 2, 2008 to its current level of $19.402, an increase of $10.181 trillion or 110.4 percent in just eight and a half years.  While this massive accumulation of debt should be worrisome despite the federal government's ability to raise nearly endless amounts of revenue through taxation, in fact, the current bond markets show otherwise.

Here are two graphs showing what has happened to the yield on 10 year and 30 year Treasuries over the same timeframe:

Since bond prices act inversely to yield, falling yields result from rising bond prices.  Bond prices rise as demand for bonds increases; the current behaviour of the bond market suggests that there has been a very significant increase in the demand for U.S. Treasuries until very recently (Q4 2016) when the Fed finally lifted off.  This is despite the fact that the Fed had been signalling higher rates for months prior to actually raising rates in December 2016. 

If we go back to Dr. Kocherlakota's musings, he notes that in the wake of the Great Depression, the never-ending crisis in Europe and other events that make investors nervous, households businesses and pension plans are looking for safe assets to protect themselves from the next financial debacle.   It is this demand that has pushed Treasury prices up and yields to all-time lows.

Let's look at some Treasury statistics.  Right now, according to the Treasury, there is $14.387 trillion in debt held by the public (excluding the intergovernmental debt that is owed from one government agency to another).  Let's see who holds this debt:

1.) Foreign Holders:

As of November 2016, foreign holders owned $5.944 trillion in Treasury bills, notes and bonds.

2.) The Federal Reserve:

The Fed currently owns $2.464 trillion worth of Treasury bonds and notes including $119 billion worth of TIPS.  One would almost say that the Federal Reserve is at least partly responsible for the "misbehaviour" in the Treasury market.   

If we total up the holdings of foreigners and the Federal Reserve, of the $14.387 trillion in Treasuries floating around out there, $8.408 trillion or 58.4 percent of the total is not available to households, businesses and pension plans as investments.  

Recent data from the Federal Reserve shows just how distorted the market for Treasuries has become:

Given that a very significant portion of the global sovereign debt pool is currently yielding negative as shown on this graphic:

...investors will find and already are finding it increasingly difficult to find so-called safe haven investments like Treasuries that have a positive yield, forcing them into higher risk investments like corporate bonds and the world's equity markets.  These bond market distortions are already having a negative impact on the funding ratio of pension plans and the ability of individual retirees to fund their retirements from their savings.  Despite the fact that common sense tells us that the current U.S. federal debt has reached or surpassed the danger point, an observation that will become quite apparent when the next recession hits, there really does appear to be a shortage of U.S. government debt.  Odd, isn't it?  

The Federal Reserve's Treasury Dilemma

Updated March 2016

While everyone focuses on whether the Federal Reserve will raise interest rates again in 2016, one aspect of the Fed's actions are being pretty much ignored as you will see in this posting.

Let's look at what has happened to the Federal Reserve's balance sheet since it took unprecedented actions to rescue the U.S. economy back in September 2008:

The Fed's balance sheet grew from around $900 billion in August 2008 to its current level of $4.535 trillion on January 14, 2016, an increase of $3.635 trillion or roughly 400 percent.

Let's look at the latest statistical release from the Federal Reserve dated March 10, 2016 which shows us the assets held by the Fed:

As of March 2016, the Federal Reserve held $2.461 trillion worth of U.S. Treasuries which was composed of $2.346 trillion worth of Treasury notes and bonds and $98.5 billion worth of inflation-indexed Treasury notes and bonds.  Thanks to its long-term monetary policy experiment, the Federal Reserve is now the largest holder of government debt, owning 21.7 percent of the total $11.348 trillion in outstanding Treasury notes, bonds and TIPS. 

Now, let's look at a table that shows us the maturity distribution of the Federal Reserve's massive inventory of U.S. Treasuries:

In case you are interested or curious, here is a complete listing of all of the Treasury notes and bonds held by the Federal Reserve.  One problem that has occurred because of the Fed's massive holdings is that there are less Treasuries for sale on the open market, meaning that certain Treasuries either command a premium (i.e. higher price and lower yield because supply is lower than demand) or trades simple fail because there is a shortage of certain Treasuries as shown on this graphic which shows the growing daily Treasury settlement delivery fails in billions of dollars for the last year:

Over the next year, the Federal Reserve has a total of $216.11 billion worth of Treasuries that are maturing, a far larger volume than in any other year since QE1 began.  If we look further down the line, over the next five years, the Fed will hold $1.334 trillion worth of maturing Treasuries.  Here is a table showing a more detailed view of the Fed's maturing inventory of Treasuries:

The Federal Reserve has already announced that it will not be selling its massive inventory of Treasuries to normalize its monetary policy, rather, it will raise interest rates by increasing the interest rate that it pays banks on the reserves deposited at the Fed, which it did on December 17, 2015 (up to 0.50 percent from 0.25 percent) and continuing its experiment with reverse repurchase agreements. In other words, as shown here, the Fed will roll over its maturing Treasury securities into new Treasury securities:

"As directed by the FOMC, the Desk is rolling over maturing Treasury securities at auction. However, for operational efficiency, when the proceeds received by the SOMA from Treasury securities that mature on a given day total less than $2 million, the Desk will allow those securities to mature without reinvestment.

For example, if on a given date the SOMA holds two Treasury coupon securities maturing with balances of $0.5 million and $1.1 million, the full $1.6 million would be allowed to mature without reinvestment. However, if the balances of the maturing securities on that date were instead $0.5 million and $1.6 million, the full $2.1 million would be reinvested into newly issued Treasury coupon securities at auction."

At its December 16, 2015 meeting, the FOMC reaffirmed its commitment to rolling over its maturing Treasuries.  Additionally, a recent speech by William C. Dudley, President of the Federal Reserve Bank of New York and Vice Chairman of the Federal Open Market Committee stated that:

"Let me close with some observations about my current thinking concerning our reinvestment of maturing Treasury securities and paydowns in our agency MBS holdings. As we noted in the December FOMC statement, we anticipate that we will continue reinvestment “until normalization of the federal funds rate is well underway.” I think this policy makes sense not only because the decision to end reinvestment will represent a further tightening of monetary policy, but also because it is difficult to assess ahead of time the impact of such a decision on financial market conditions given the lack of historical experience.

I also believe that continuing reinvestment until the federal funds rate reaches a higher level makes sense. We want to ensure that we have the ability to respond to adverse shocks by easing monetary policy by lowering the policy rate. Having more “dry powder” in the form of higher short-term interest rates seems more desirable than less dry powder and a smaller balance sheet." (my bold)

By signalling that it will continue to reinvest its massive portfolio of Treasuries, the speech by William Dudley shows that the Fed is concerned about two things:

1.) What will happen to the Treasury market when the Fed ends its unprecedented monetary policy since there is no historical precedent?  As well, since Treasury prices behave inversely to yield, as yields rise, prices will drop, leaving the Fed with a capital loss on the value of their portfolio that could prove to be very significant.

2.) Ending the reinvestment program will represent a further tightening of monetary policy because it means that the Treasury will have to make up the lost funding by selling additional debt which will push interest rates higher whether the Fed likes it or not.  

As the Fed rolls maturing issues into new debt, the amount that comes due later in this decade and into the 2020's rises, kicking any potential problems further down the road and through the next recession.  A 2010 study by Stefania D'Amico and Thomas King at the Federal Reserve Board's Division of Monetary Affairs suggests that the Fed's large-scale asset purchases of $300 billion during 2009 resulted in a persistent downward shift of the yield curve by as much as 50 basis points (one-half percent) with the largest impact being on the 10 to 15 year sector.  It is this sector that largely dictates the interest rates on mortgages and other loans.  This research suggests that we could see substantial increases in interest rates once the Fed starts to divest.   

As I have explained in many postings, no one really knows the long-term ramifications of the Federal Reserve's 7 year program of monetary policy experimentation.  As this posting shows us, the Fed's massive Treasury inventory is likely to prove problematic, particularly if they continue to rollover the hundreds of billions of dollars worth of government debt into the distant future.  The acquisition of trillions of dollars worth of Treasuries could have a detrimental impact on the Fed's ability to move interest rates in the future, particularly since reducing the inventory will put significant upward pressure on yields at a time when the global economy is looking particularly fragile.

The Looming Liquidity Crisis

A recent piece by Nouriel Roubini on the Project Syndicate website gives us a strong hint of a looming crisis in the world's markets.  While some of you may have heard of Mr. Roubini, here is a bit of background for those of you that haven't.

Dr. Nouriel Roubini is a professor of economics at New York University Stern School of Business.  He served as a senior economist for international affairs on the White House Council of Economic Advisors.  Dr. Roubini is renowned for his September 7, 2006 speech before a crowd of economists at the International Monetary Fund where he warned that the United States was likely to face a housing crash and a deep recession as shown in this excerpt:

"I argue that housing today, like the tech bust in 2000-2001 will have a macro effect; it is not going to be just a sectoral effect. I argue that U.S. consumers are now close to a ‘tipping over’ point given all the vulnerabilities I have discussed. I argue that the Fed easing will occur, so the next move is going to be a cut, but it is not going to prevent a recession. And, finally, I argue that the rest of the world is not going to be able to decouple from the U.S. even if it is not going to experience an outright recession like the United States. So on that cheerful note, I will stop."

In his latest missive, Dr. Robin discusses the emerging liquidity paradox that has appeared in the economy since the Federal Reserve and other central banks have been using unconventional monetary policies to solve the world's economic ills since 2008.  These policies have pushed up the size of the monetary base as shown on this chart:

At $3.951 trillion, the monetary base is now 467 percent larger than it was just as the Great Recession took hold at the end of 2007.   This means that the U.S. economy is flush with liquidity, thanks to the Federal Reserve's "printing presses".  All of this money has ended up lifting asset prices, including bonds of both the private and public sector, stocks and housing among others.  Asset prices, in some cases, are now decoupled from realistic valuations, particularly in the bond market where some bonds are now trading with negative (or near zero) yields.

Dr. Roubini goes on to note the two relatively recent bond market "hiccoughs", the first of which is shown on this chart:

As soon as Ben Bernanke telegraphed that the Fed would begin to taper its purchases of long-term securities in the spring of 2013, interest rates shot up by nearly 100 basis points in a very short period of time.  This event is known as the "Taper Tantrum".  In fact, as shown on this graphic, the main part of the Taper Tantrum took place over a very, very short period of time:

Again, on October 15, 2014, U.S. Treasury yields plunged by 34 basis points (7 to 8 standard deviations) in a matter of minutes, an event that should have occurred only once in three billion years according to statisticians.  According to Nanex, liquidity evaporated in Treasury futures, prices skyrocketed and yields plunged.  Here is a quote from Wall Street on Parade:

 "One of the key concerns floating around Wall Street is that the Federal Reserve itself may be a source of liquidity stresses in the Treasury market place. As a result of its previous, massive Quantitative Easing (QE) programs, it’s sitting with $2.4 trillion in Treasury securities on its balance sheet as of its report dated April 2, 2015. Keeping that supply out of the marketplace is part of the Fed’s monetary policy strategy to keep interest rates low and boost economic activity. However, in times of stress when trillion dollar banks and billion dollar hedge funds want to instantly flip out of junk bond ETFs, stocks and other riskier assets and into the safe haven of U.S. Treasuries, there may not be enough supply to go around given the trillions of dollars in high risk assets that now dominate the globe."

Dr. Roubini observes that one of the differences between the world's equity and fixed income markets is that bonds of all types are not traded on exchanges that are as liquid as stock exchanges.  Most bond trades take place over-the-counter in markets that are relatively illiquid.  Many of these bonds are held in funds that allow investors to divest of their positions at any time.  This means that banks which offer these funds containing these illiquid bond assets may be forced to sell at a moment's notice (i.e. on demand); the need to sell the illiquid assets into an illiquid market could push prices down very, very quickly.  In other words, there is a significant liquidity mismatch in the Treasury market that could cost fixed income investors dearly.  The events of both the spring of 2013 and October 15, 2014 give us a sense of just how painful that lesson could be to investors.

Dr Roubini concludes with the following:

"This combination of macro liquidity and market illiquidity is a time bomb. So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices. But, over time, the longer central banks create liquidity to suppress short-run volatility, the more they will feed price bubbles in equity, bond, and other asset markets. As more investors pile into overvalued, increasingly illiquid assets – such as bonds – the risk of a long-term crash increases.

This is the paradoxical result of the policy response to the financial crisis. Macro liquidity is feeding booms and bubbles; but market illiquidity will eventually trigger a bust and collapse." (my bold)

The liquidity mismatch issue is yet another unintended consequence of the Federal Reserve's six year experiment with a series of unproven monetary policies.  This one could prove to be just as painful to investors as the stock market readjustment in 2008 - 2009.