Wednesday, April 29, 2009

Where's the Debt?

This recession (call it what you will) is predicated on debt. Too much debt. I'm indebted, you're indebted, wouldn't you like to be indebted too?

The world is surely more interconnected than it was and as the makers of Tamiflu will tell you, when one of us sneezes we all get sick. But they will also tell you to stay away from sick people. It's not easy to isolate oneself, but we can try. So too is it with United States as a borrower. It's impossible to isolate us, but the rest of the world will try to stay out of sneeze distance if possible.

The U.S. currently has $3 Trillion of its debt in the form of Treasury securities around the world. The biggest as we all know is China, but there is plenty to go around. Given the state of the US economy, future liabilities and government policies it is a certainty that the rest of the world is trying to figure out how to let loose of the United States tarbaby. It likely will not happen quickly as such disruptions create problems globally, but it will happen. It IS happening.

The Chinese proposal of substituting the US Dollar with IMF Special Drawing Rights is a non-starter but it IS a warning. The world is looking. There is no alternative, yet. What keeps the US dollar up is every other currency being worse.
The Chinese have been hard at work to diversify a bit from the US dollar. They increased gold holdings significantly in the past year. They have been buying copper and hard asset productions. Whether with equity positions in mining companies or long term contracts for oil they've been on a shopping spree with a $3 trillion dollar line of credit.

What I have been watching is the action of the yields on treasuries and the policy moves. On March 18, the ten year bond was yielding 3.09% when trading opened. The Fed then announced it would buy $1.2 Trillion in treasuries. This tidal wave of impending demand pushed yields down immediately to under 2.50%. Today, the 10 year treasury yield is 3.02%. In other words the prospect of over a trillion dollars of buying has brought interest rates down, not at all. What happens when the Fed stops?

In the UK they experienced a failed auction of government debt. Not enough bidders showed up for the amount offered. In the US it is unlikely we would ever experience that as the Fed has taken it upon themselves to "monetize" the debt by being the buyer of last resort. Something has to give. The dollar? Inflation? Taxes?

Everyone seems to agree that shorting the treasury bond makes sense in this bubble. Usually I would think too many on the same side of the trade, but this might just be the mother of all bubbles, so be patient, but pay attention. The top of the 10 year rate has bounced off 3.00% repeatedly this year. When it doesn't bounce, the hound may have broken its leash. If you have all of your retirement money in bonds, pay CLOSE attention.

The quadrillion dollar question is which, what, and when.

John Barnyak