Entering the Financial Twilight Zone

Following today's news that the Federal Reserve opted against expanding its program of buying Treasurys, government bond yields jumped, pushing the "big figure" on the five, 10, and 30-year benchmarks above the psychologically important two, three, and four percent levels.

	CURRENT YIELD	YIELD CHANGE
5-Year	2.02	+.053
10-Year	3.09	+.087
30-Year	4.02	+.067

(Source: http://www.bloomberg.com/markets/rates/index.html)

Some might find it ironic -- or surreal, perhaps -- that the ostensible reason for today's rise in yields was the fact that one arm of our government was not going to boost purchases of the rapidly expanding supply of paper being produced by another arm of our government.

Yet that is likely to be only one of the many distortions we can expect to see in the months and years ahead as Washington moves whole hog into the realm of the financial twilight zone. In "How Government Guaranteed Bank Debt May CRUSH Public Borrowing," Clusterstock details another perverse outcome in the making.

It's no secret the the federal government's need to borrow has sky-rocketed. Thanks to the various bailouts and stimulus measures, expenditures by the feds have increased by one third and are likely to grow even higher. Meanwhile, the economic slowdown has decreased the amount the government collects in taxes. The only way to bridge the gap is more borrowing.

While many are confident that the global appetite for the soveriegn debt of the United States will remain robust, some of the government's own programs may start to diminish that appetite. The government's guarantees of various kinds of debt issued by financial institutions essentially makes some bonds issued by banks as "risk free" as Treasuries. But these bonds pay higher yields than government debt, which should make them more attractive for risk-adverse investors looking to maximize their returns on investment.

A financial sector panel took up this risk yesterday in Washington DC's Hays Adams hotel. The occassion was a meeting of the Treasury Borrowing Advisory Committee of the Securities Industry and Finacial Markets Association, the leading securities industry trade association. 

The member presented a slide indicating that debt issuance by sovereign issuers continues to rise. This was followed by a series of sides depicting flows into various asset classes. The member pointed out that Treasury issuance has benefited from a flight to quality and general risk aversion. Aggregate foreign inflows into US assets have shifted dramatically in favor of Treasuries.

So far the Treasury has benfitted from what is called a "flight to quality," with investors seeking the safety of government securities in rocky markets where corporate debt and municipal debt is at risk of defaulting, the committee members were told in a presenation by one of its members. Because of this, the government has been able to borrow cheaply and the Treasury's share of the overall debt market has been growing.

But the government's guarantees may be creating competition for safe debt, which could mean the government's borrowing costs would increase. Although the guaranteed bank debt is viewed as less liquid and less standardized than Treasuries, the ever-increasing size of the guaranteed debt offerings may at some point bite into the Treasuy's market share.

The committee noted that issuance of quasi-governmental debt is projected to increase dramatically.

"One member stated that many of these assets were directly competing with Treasuries and cited an expected $50 billion of issuance of Build America bonds as an example. Another member noted that FDIC-backed debt offered a significant pick-up in yield over comparable Treasury debt and that substitution by traditional Treasury investors was occurring," the offical minutes of the meeting explain.

The bottom line is thatpolicy makers should not assume that there is no cost to offering guarantees of private debt. Even if banks don't default and so those guarantees never have to be paid out, at some point the growth of the quasi-government debt market will make it more difficult and more expensive for the government to borrow.

Comments

[Dave W]

I've read elsewhere that as of today when the Treasuries sold off, there was actually a point at which Agencies were trading at a premium to Treasuries creating a negative yield spread. Theoretically should never happen but welcome to the twillight zone.

[Jr]

"now" entering? Michael, you've been paying attention. We've BEEN there.

This is actually fascinating.

I liken it to learning how to drive in Chicago as a teenager - that wasn't how people were supposed to drive (it was psychotic, frightening, dangerous, and probably illegal most of the time) but that's where I learned how to go 90 on the freeway at 16.

Now that I'm almost 30, I don't drive that way in California. But, you know, if I found myself on a Chicago freeway I could certainly keep up.

When the next Great Recession happens 40 years from now or whatever cycle we're at, I'm going 95! Weee Bizarro World! Personally I'm entertained by stories like governments "secretly" buying each others' debt (Bank of England and the Fed? Not that far-fetched) and Treasury auctions bombing.

[scottt]

Is the Federal reserve an arm of the govt ? Or is the govt an arm of the federal reserve ?
Or are we all just being strong-armed by the fascist capitalist super-criminals to the point where it doesnt really matter what ya call anything ?

[Rocky]

In case you missed it on Bloomberg, the following article makes for good reading for current or former Wall St. types.

http://www.bloomberg.com/apps/news?pid=20601109&sid=a0nJKlCkI47U&refer=home