http://albertpeia.com/screwturnsagainstus.htm
‘The following is an excerpt from
the latest issue of Private Wealth Advisory. In it I outline the
relationship between the Fed’s commitment to low interest rates, the scramble
for high grade collateral driving the sovereign bond markets, and how the whole
mess will eventually come crashing down.
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The US Fed is
committed to keeping interest rates low for the simple fact that if interest
rates were to rise then the payments on the debt would send the US into an
EU-syle debt crisis along with the commensurate intense austerity measures
being implemented.
Unfortunately for
the Fed, the bond markets may indeed force this in spite of the Fed’s efforts.
Weimar Germany, like
most historic episodes of hyperinflation, occurred when Germany’s Central Bank
began monetizing its debts. This worked until the country lost credibility in
the international bond markets at which point the Central Bank was forced to
monetize everything resulting in a currency collapse and one of the worst
episodes of hyperinflation in history.
The US has been
moving increasingly down this path which each new QE program. The two reasons
the US has not yet entered an inflationary death spiral are:
1) The
fact that the US continues to maintain its credibility in the bond markets (at
least compared to Europe and Japan).
2) Large
financial institutions’ needs for high-grade sovereign bond collateral.
Regarding #1, the US
has never defaulted on its debt. Compared to Germany (another safe haven),
which has defaulted on its debts twice in the last 100 years, the US remains
one of the most credible governments in the world, regardless of how bad the
country’s finances are becoming (for now at least).
Regarding the
collateral situation, as I’ve explained in recent articles one of the most
critical issues in the financial system is the shortage of high grade
collateral to backstop the $700 trillion derivatives market.
With France and the
ESM bailout fund recently losing their AAA status this issue is only getting
worse. The US, despite losing its AAA rated status is still consider high grade
due to its having never defaulted on its debt. With that in mind, the Fed
decision to take US Treasuries at a time when more and more countries are
losing their AAA rated status means that even less high grade collateral will
be in the system.
Indeed, as I’ve
noted before, because so much of the US debt market is already held by
government controlled entities, the Treasuries shortage is even worse than the
below article indicates.
Clearinghouses, run
by firms such as Chicago-based CME Group (CME) and London-based LCH.Clearnet
Group, make traders provide collateral, including government bonds, that can be
seized and easily converted into cash to cover defaults. Traders may
need from $2 trillion to $4 trillion in extra collateral to meet the new
requirements, according to Timothy Keaney, chief executive officer of BNY
Mellon Asset Servicing.
The trouble is
finding all that high-grade debt. The U.S. had $10.8 trillion in Treasuries
outstanding at the end of August. Other countries, including Japan and
European nations rated AAA or AA, had about $24 trillion of debt in the second
quarter of 2011, according to an April report by the International
Monetary Fund. Those government securities are already in heavy demand from
central banks and investors.
The solution:
At least seven banks plan to let customers swap lower-rated securities that
don’t meet standards, in return for a loan of Treasuries or similar holdings
that do qualify, a process dubbed “collateral transformation.” The maneuver allows investors
who don’t have assets that meet a clearinghouse’s standards to pledge corporate
bonds or mortgage-linked securities to a bank in exchange for a loan of Treasuries.
The investor then posts the Treasuries—the transformed collateral—to the
clearinghouse. The bank earns fees plus interest, and the investor is obliged
at some point to return the Treasuries. In effect, the collateral is being
rented…
JPMorgan Chase
(JPM) and Bank of America (BAC) are already marketing their new
collateral-transformation desks, executives at the companies say. Other banks
confirmed they’re planning to offer the service too, including Bank of New York
Mellon (BK), Barclays (BCS), Deutsche Bank (DB), and State Street (STT).
http://www.businessweek.com/articles/2012-09-20/a-shortage-of-bonds-to-back-derivatives-bets
Here’s the actual
amount of Treasuries available to the banks:
|
Total
US Sovereign Debt |
$16
trillion |
|
Foreign
Nation holdings |
$5.4
trillion |
|
Intergovernmental
holdings |
$4.8
trillion |
|
US
Federal Reserve |
$1.5
trillion |
|
Remaining |
$4.3 trillion |
Indeed, as the below
article reveals, the search for high quality collateral is one of the primary
items holding up the Treasury market. The Treasury’s latest information reveals
that:
Foreign ownership of
U.S. Treasury securities rose to a record level in October, a sign that
overseas investors remain confident in U.S. debt despite a potential budget
crisis.
Total foreign
holdings of U.S. Treasurys rose to $5.48 trillion in October, the Treasury Department said
Monday. That was up 0.1 percent from September. Still, the increase of $6
billion was the weakest since total holdings fell in December 2011.
China, the largest
holder of U.S. government debt, increased its holdings slightly to $1.16
trillion. Japan, the second-largest holder, boosted its holdings by a smaller
amount to $1.13 trillion. Brazil, the country with the third-largest holdings,
increased its total to $255.2 billion.
My point with all of
this is that the search for collateral will drive yields lower… until the bond
markets truly begin to spin out of control. In the meantime, the US Fed is
playing a very dangerous game by purchasing as many Treasuries as it is. But
that game can last much longer than anticipated.
How precisely these
issues will finally play out is a mystery. But the consequences will be
tremendous. And enormous fortunes will be made by those who get it right. The
first key clues will be when Bunds and Treasuries begin to nose dive in a big
way.
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Best Regards,
Graham Summers