OPINION

Updated March 27, 2012, 6:49 p.m. ET

Demand for U.S. Debt Is Not Limitless
.
In 2011, the Fed purchased a stunning 61% of Treasury issuance. That can't last.
.

By LAWRENCE GOODMAN

.





.
The conventional wisdom that nearly infinite demand exists for U.S. Treasury debt is flawed and especially dangerous at a time of record U.S. sovereign debt issuance.


.
The recently released Federal Reserve Flow of Funds report for all of 2011 reveals that Federal Reserve purchases of Treasury debt mask reduced demand for U.S. sovereign obligations. Last year the Fed purchased a stunning 61% of the total net Treasury issuance, up from negligible amounts prior to the 2008 financial crisis. This not only creates the false appearance of limitless demand for U.S. debt but also blunts any sense of urgency to reduce supersized budget deficits.




Still, the outdated notion of never-ending buyers for U.S. debt is perpetuated by many. For instance, in recent testimony before the Senate Budget Committee, former Federal Reserve Board Vice Chairman Alan Blinder said, "If you look at the markets, they're practically falling over themselves to lend money to the federal government." Sadly, that's no longer accurate.
.



.It is true that the U.S. government has never been more dependent on financial markets to pay its bills. The net issuance of Treasury securities is now a whopping 8.6% of gross domestic product (GDP) on average per annummore than double its pre-crisis historical peak. The net issuance of Treasury securities to cover budget deficits has typically been a mere 0.6% to 3.9% of GDP on average for each decade dating back to the 1950s.



.

But in recent years foreigners and the U.S. private sector have grown less willing to fund the U.S. government. As the nearby chart shows, foreign purchases of U.S. Treasury debt plunged to 1.9% of GDP in 2011 from nearly 6% of GDP in 2009. Similarly, the U.S. private sector—namely banks, mutual funds, corporations and individuals—have reduced their purchases of U.S. government debt to a scant 0.9% of GDP in 2011 from a peak of more than 6% in 2009.


.
The Fed is in effect subsidizing U.S. government spending and borrowing via expansion of its balance sheet and massive purchases of Treasury bonds. This keeps Treasury interest rates abnormally low, camouflaging the true size of the budget deficit. Similarly, the Fed is providing preferential credit to the U.S. government and covering a rapidly widening gap between Treasury's need to borrow and a more limited willingness among market participants to supply Treasury with credit.
.
The failure by officials to normalize conditions in the U.S. Treasury market and curtail ballooning deficits puts the U.S. economy and markets at risk for a sharp correction. Lessons from the recent European sovereign-debt crisis and past emerging-market financial crises illustrate how it is often the asynchronous adjustment between budget borrowing requirements and the market's appetite to fund deficits that triggers a shock or crisis. In other words, budget deficits often take years to build or reduce, while financial markets react rapidly and often unexpectedly to deficit spending and debt.


.
Decisive steps must be implemented to restore the economy and markets to a sustainable path. First, the Fed must stabilize and purposefully reduce the size of its balance sheet, weaning Treasury from subsidized spending and borrowing. Second, the government should be prepared to lure natural buyers of Treasury debt back into the market with realistic interest rates.


.
If this happens, the resulting higher deficit may at last force the government to make deficit and entitlement reduction a priority. First and foremost, however, we must abandon the conventional wisdom that market demand for U.S. Treasury debt is limitless.




Mr. Goodman is president of the Center for Financial Stability and previously served at the U.S. Treasury.
.
Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved


Markets Insight

. 
March 26, 2012 11:11 am
.
Investors must not be cowed by end of bond run
.

Powerful new dynamics are shaping the US bond market in ways that will require many investors to fundamentally rethink their portfolios. Chief among these is a shrinking supply of fixed income assets and a ravenous investor appetite for yield, which will combine to keep interest rates lower for much longer than most people expect.



We have all heard the bears’ case for bonds: with governments and consumers in the developed world drowning in debt and negative real interest rates on many sovereign bonds, yields can only risequickly.

 

.

Not so fast: The confluence of profound supply and demand factors, with a dash of monetary policy distortion thrown in, will ensure bonds remain well-bid – and interest rates capped – for years to come.


.
.
On the supply side of the equation, investors are confronting a US bond market that has shrunk since the financial crisis and is likely to keep shrinking. Why?


.
A big reason is the contraction in financial industry bond issuance. Globally, banks are deleveraging in the wake of the financial crisis and subsequent regulatory push to pare down risk. US financial institutions alone will reduce their debt by $360bn this year. Even the supply of US Treasuries is expected to decline.

.
Gross US Treasury issuance in 2013 could be $1.9tn, according to Credit Suisse research, down 17 per cent from 2010 levels. And with the Federal Reserve purchasing Treasury bonds, net supply looks even more constrained.

.
For investors with high quality investment mandates, the supply challenge may be even greater. Downgrades of US and French government debt by Standard & Poor’s have cut the agency’s triple A sovereign universe by more than half. At the same time, investors have never been hungrier for yield.


.
Public and private pensions are underfunded and face negative real rates on many traditionally core bond holdings. Most personal savings and retirement accounts will not be able to finance their owners’ increasingly long retirements, especially after some $8.7tn in wealth evaporated after the 2006 peak of the US housing market.




As a result, many companies are topping up their pension plan assets and shifting their allocation mix to fixed income to match their liabilities better. BlackRock expects US corporate pensions will put nearly $1.2tn into long-term bond strategies over the coming decade. US insurance companies may buy $600bn of bonds this year alone.



Compounding these trends are the significant market distortions resulting from monetary policy. The Fed’s near-zero interest rate policy, rounds of quantitative easing and Operation Twist have pressured yields – and the yield curvelower than they naturally would be.



.
While these policies have boosted equities and other risk assets by forcing investors to search for higher yields and returns, there are risks. These include the potential for future inflation and of policy distortions temporarily masking deeper structural problems in the global economy.



As a result, we think yields on 10-year Treasuries could drift higher, to the mid-to-high 2 per cent range by year-end, from about 2 per cent at present. What does all this add up to?



First, the onlybubble” in the bond market appears to be the overinflated talk of bond market bubbles in recent years. All signs point to bonds remaining well-bid, even if rates rise modestly. We simply do not see a bear market on the horizon that would force investors away from bond markets.



.
Second, as credit risk creeps into the government bond sector, investors should increasingly look to corporate bonds when seeking safety and yield. Corporations have worked diligently to improve their balance sheets in recent years and fundamentals on corporate credits are as good as they have ever been. That’s not to suggest that we won’t see some volatility in credit spreads. A few defaults could still stir markets from time-to-time, but the sector looks strong overall.



Finally, given low yields and limited potential for price appreciation, US Treasuries should not be a primary source of yield in most portfolios. The best opportunities exist in assets such as high yield and investment-grade corporate credits as well as certain asset-backed securities.





.
The 30-year bull market for bonds, which saw long-term Treasury yields decline from the mid-teens in the early 1980s, is over. But rates won’t spike dramatically soon. Shrinking supply, high demand and ultra-loose monetary policies will conspire to keep a tight lid on yields. For investors starved of yield, this much is clear: a new playbook is needed for success in fixed income. Understanding these new market dynamics and risks is a place to start.


.
Rick Rieder is BlackRock’s Chief Investment Officer of Fixed Income, Fundamental Portfolios

.

Copyright The Financial Times Limited 2012.


Hmmm… Holland


For your Outside the Box today I treat you to another big, juicy slab of Grant Williams' Things That Make You Go Hmmm… I don't want to be all Grant all the time, but this is just so good I couldn't resist. This week, Grant is digging deep into the history and mystery of the European Union, taking us all the way back to the first inter-country treaty in April 1951 and then following the rather tortuous bureaucratic proceedings that led, by hook and by crook, to today's increasingly problematic eurozone.



Grant then zeroes in on the ever-stalwart Dutch, who, it now appears, are in something of a pickle. He notes that the Dutch "were signatories to the Treaties of Paris and Rome and to every major European Treaty since and are staunch supporters of a unified Europe as well as having a reputation for being amongst the more fiscally disciplined members of the EU." And in September of last year, the Dutch prime minister and his finance minister penned a rather incendiary little diatribe on eurozone behavior that built, with eminently sensible Dutch logic, to the conclusion that "Countries that do not want to submit to this [new, rigorous fiscal] regime can choose to leave the eurozone. Whoever wants to be part of the eurozone must adhere to the agreements and cannot systematically ignore the rules. In the future, the ultimate sanction can be to force countries to leave the euro."


.
How unfortunate, then, that a mere six months later – and just days after Spain's unilateral decision to favor its own budget projections over those dictated by Brussels, who did we find but the Dutch confessing that they too would violate, by a mile, the fiscal deficit limit imposed by the EU's new treaty. And to make matters worse, Geert Wilders, head of the far-right-wing Freedom Party and a key player in the right-of-center coalition that now governs Holland, has been making noises about a Dutch referendum on continued eurozone membership.

.
Grant then jumps right across the Channel to catch us up on the antics of the English government, whose much-ballyhooed austerity program appears to be anything but, depending as it does on some rather figmentary revenue assumptions and other fiscal legerdemain. I haven't included that portion of this issue of Hmmm…, because I want to keep the focus this week on eurozone woes (England is not in the euro and didn't sign the new EU treaty, arousing much Continental ire), and to mention that I'm in Paris, attending a very powerful conference on central-bank monetary policy and strategies for dealing with sovereign debt.


.
Organized by the Global Interdependence Center (GIC), the conference could hardly be more timely. I'm here with good friend (and long-time GIC supporter) David Kotok, who mentions today in his own commentary that:

.
"Our private meetings here involve bankers, central bankers, investors, and money managers – the gamut of those interested in financial markets and economics. We find that one theme persists.

.
All of them are watching the credit spreads involving Portugal and Spain. They realize the market is sending a message of concern.


The market is saying that the episode with Greece is not over, and the contagion is spreading in spite of the massive liquidity injections of the European Central Bank. They observe and discuss the use of collective action clauses and how they have to adjust their portfolios now that a government has inserted itself in a retroactive forced alteration of a debt structure. In public, they are polite, but they dissect the risks strenuously. In private, the debates become fierce." (You can read David's whole piece on the Cumberland Advisors website.)


He's right: the tension here, both behind closed doors where the "players" assemble and in public, between the European leadership and their increasingly disgruntled constituencies, is palpable.

.
And yet, after a tough winter, Paris is bursting with the hopeful energy of spring, and I'm very glad to be here.

.
Your learning a lot and loving it analyst,

.
John Mauldin, Editor
Outside the Box






Things That Make You Go Hmmm...
.
Grant Williams .
March 25, 2012


On March 25, 1957 in Rome, two representatives each from West Germany, Italy, the Netherlands, Belgium and Luxembourg sat around a large, fancy table, took out their large, fancy fountain pens and signed a rather large and fancy document that was rather grandly known as The Treaty of Rome. At a stroke the European Economic Community (or 'Common Market') was established (along with the European Atomic Energy Commission those Europeans do LOVE a commission), the purpose of which was to gradually eliminate trade barriers between member nations and introduce common policies for agriculture, transportation and economic relations between both the member states and those outside the Treaty.

.
In 2007, on the 50th anniversary of the signing of the treaty, one of the lawyers responsible for its drafting, Pierre Pescatore, told the BBC that all was not as it seemed that day:

.
"They signed a bundle of blank pages... The first title existed in four languages and also the protocol at the end; nobody looked at what was in between."

.
A fitting start for what would eventually morph into the European Union as we know it today. The reason for the hastiness in getting an 8-inch high stack of papers signed by the dignitaries present? Fears that General de Gaulle could soon return to the French presidency and block the treaty.


And so it began.


But the origins of the Treaty of Rome were founded in the Treaty of Paris which created the European Coal and Steel Community (ECSC) 6 years earlier, in April 1951, in an attempt to bind together a continent rent asunder by the horror of WWII. The architects of this political construct were a pair of Frenchmen, Robert Schuman (the French Foreign Minister) and Jean Monnet (a civil Servant), and their idea was to tie together the coal and steel industries of France and Germany under a High Authority that would allow other European countries to join should they wish to do so, thus reuniting the war-torn countries of Europe and forever banishing the chances of another conflict between them. Italy and the Benelux countries joined the negotiations and, on April 18 1951, the Treaty was signed.


The intervening 6 years between the signing of the Treaty of Paris and that of Rome, were a sign of what was to come in Europe as Commission after Commission, several Assemblies, a couple of Communities and a bunch of Committees were formed and countless Reports written to be presented at numerous Conferences in an attempt to further the idea of a united and peaceful Europe. This passage does a very nice job in outlining just how bureaucratic Europe was, even in its nascence:


(Wikipedia): The Spaak Report drawn up by the Spaak Committee provided the basis for further progress and was accepted at the Venice Conference where the decision was taken to organise an Intergovernmental Conference. The report formed the cornerstone of the Intergovernmental Conference on the Common Market and Euratom at Val Duchesse in 1956.

.
The outcome of the conference was that new communities would share the Common Assembly (now Parliamentary Assembly) with the ECSC, as it would with the Court of Justice. However they would not share the ECSC's Council of High Authority. The two new High Authorities would be called Commissions, this was due to a reduction in their powers. France was reluctant to  agree to more supranational powers, and so the new Commissions would have only basic powers and important decisions would have to be approved by the Council

.
Colour me cynical if you must, but surely anybody reading this paragraph in 1955, would have had a fairly good idea which direction this project was headed?

.
But I digress.

.
The Treaty of Rome would form the foundation for what would later become the EU that we know and love 50+ years on in all its bureaucratic glory and amongst those original signatories as well as those that abstained are the clues as to just how important a part the idea of 'Europe' was and is to various countries.

.
Case in point: the Netherlands and the United Kingdom.

.
The Dutch were signatories to the Treaties of Paris and Rome and to every major European Treaty since and are staunch supporters of a unified Europe as well as having a reputation for being amongst the more fiscally disciplined members of the EU. When Greece and, latterly, Spain prove to be a little recalcitrant when it comes to balancing the cheque book, Europeans shrug and express dissatisfaction but little surprise. When the Dutch announce they will be a little short in meeting their fiscal targets, you can bet your bottom euro that eyebrows will be raised.

.
A mere six months ago, in September of 2011, Dutch Prime Minister Mark Rutte and his Finance Minister, the delightfully-named Jan Kees de Jager, penned an opinion piece in the Financial Times that was entitled 'Expulsion From The Eurozone Has To Be The Final Penalty' in which they laid out their views on fiscal profligacy amongst the more prodigal (Southern) states in the union. Right from the outset, Rutte and de Jager were in no mood to take prisoners:

.
(FT): The eurozone is in stormy waters. The turmoil on the financial markets shows no sign of abating. Tackling the debt crisis is complex and calls for several immediate measures. But amid our hectic day-to-day efforts to fight the crisis, we need to ask how we can guarantee a stable euro and prosperous Europe in the long term.

.
What is to be done? Our answer is that we must anchor the agreements we have made more firmly and take tougher action to enforce them.

.
Tough talk indeed from two hitherto bit-part actor in the Merkozy/Shaueble/Juncker Show.

.
Clearly warming to the sudden glare of the spotlight, Rutte and de Jager took off their jackets, loosened their ties and rolled up their sleeves:

...(b)ut the main cause of the current problems is that some countries played fast and loose with the very rules designed to guarantee budgetary discipline. Other countries allowed that to happen, and this took place at a time when the financial markets were being rapidly integrated. The result is that acute financial problems can spread from one country to another at lightning speed.

.
So what is to be done now? We must return to the anchors of the eurozone. The rules are still valid, but all participants must abide by them. If the eurozone is to survive in its present form as a stable currency union that supports the internal market and our prosperity, there needs to be radical break with the past.

.
Ah yes, but it's all very well proposing a 'return to the anchors of the eurozone', but practically speaking, what does that entail, we wondered?

.
Well, we weren't left wondering for long:

.
What we propose is twofold, and builds on the ideas already put forward by the French and German leaders. First, we call for independent supervision of compliance with the budgetary rules. Second, we believe that countries that systematically infringe the rules must gradually face tougher sanctions and be allowed less freedom in their budgetary policy.

.
Independent supervision requires a commissioner for budgetary discipline. His or her powers should be at least comparable to those of the competition commissioner. The new commissioner should be given clear powers to set requirements for the budgetary policy of countries that run excessive deficits. The first step is to require the country concerned to make adjustments to its public finances.

.
If the results are insufficient, the commissioner can force a country to take measures to put its finances in order, for example by raising additional tax revenue. At this stage sanctions can also be imposed, such as reduced payments from the European Union Cohesion and Structural Funds, or higher contributions to the EU budget. The final stage will involve preventive supervision, and the budget will have to be approved by the commissioner before it can be presented to parliament. At this stage, the member state's voting rights can also be suspended.

.
Countries that do not want to submit to this regime can choose to leave the eurozone. Whoever wants to be part of the eurozone must adhere to the agreements and cannot systematically ignore the rules. In the future, the ultimate sanction can be to force countries to leave the euro.

.
Bravo! Finally, amidst the back and forth and contradictory statements of the main players on the EU stage, some clear, concise and sensible steps proposed by one of Europe's mainstays.

.
But September was a LONG time ago and a matter of days after Spain's unilateral decision to abide by its own budget deficit target of 5.8% as opposed to the mandated 4.4% was announced (and a compromise quickly reached by EU finance ministers who took Senor Rajoy at his word that the 2013 target of 3% would still be met.....<blink>), rumblings began about the likelihood of the Dutch taking on the role of (unlikely) Euro Bad Boys:

.
(The Economist): It was a far cry from the bright autumn day in 2010 when the smiling leaders of the three right-of-centre Dutch parties came together to announce a deal to run the country. The Liberals, the largest party, would form a minority coalition with the Christian Democrats. Outside support from Geert Wilders's Freedom Party would give the government a slim majority in parliament. This year, on a foggy March morning, the same three leaders looked sombre in the face of a daunting task: how to cut another €9 billion ($12 billion) from the budget for 2013 when the economy is already in recession.

.
The extra cuts are needed to deal with what forecasters say would otherwise be a 2013 budget deficit of 4.5% of GDP, way over the 3% limit enshrined in the euro zone's new fiscal pact. Yet Mr Wilders is likely to object. Indeed, he is in an objecting mood: this week he presented a report commissioned from British researchers making the case for Dutch withdrawal from the euro. Mr Wilders, who wants a referendum on the matter, claims that the country has not profited and may even have lost from its membership of the single currency.

.
Ten days after The Economist published that article, the Dutch officially jumped the shark:


(UK Daily Telegraph): Just a few weeks ago officials from Madrid begged in Brussels for their fiscal targets to be relaxed they said the current ones were "suicidal" for Spain. Jan Kees de Jager, the Dutch finance minister, was among them who demanded the answer to be "neit".

.
So now fiesta, forever, all night long today the Netherlands Bureau for Economic Policy Analysis (CPB) said the country's budget deficit could increase to 4.6pc of GDP during 2013 and 2014. The level drives a coach and horses through the fiscal pact which is less than three weeks old.