U.S. Treasury Sweating Bullets over Financing Swelling Deficits

A Treasury auction earlier in the week for two-year debt drew a lacklustre response, setting the stage for what followed a couple of days later, when an auction for five-year debt was conducted. To say that the results were below expectation would be a severe understatement. To convey the importance of what occurred , take the words of William O'Donnell, who heads U.S. Treasury strategy at RBS Securities in Greenwich Connecticut:

"It was just a horrendous result, it was the weakest bid-to-cover since September 2008, and by my numbers it was the biggest tail since February 1993. It was just a very, very weak result."

The auction sold $39 billion in 5-year debt at yields far above what had been anticipated, in the process sinking the value of Treasury bonds. This occurrence is a harbinger of the growing fiscal dangers that are now a full component of the ongoing Global Economic Crisis.

The warning is crystal clear. Before the onset of the current financial and economic crisis, the U.S. had structural deficits measured in the hundreds of billions of dollars. Now, however, the fiscally toxic combination of Wall Street bailouts and economic stimulus programs requiring massive public borrowing have created the unprecedented phenomenon of multi-trillion dollar deficits, equal to 15% or more of the entire United States GDP. If would be bad enough if only the U.S. was engaged in such staggeringly high levels of public borrowing. However, virtually every major economy on the globe, including China and Japan, America's two largest creditors, are also engaging in large deficit-financed stimulus programs. At a time when the U.S. requirement for credit is ballooning, its traditional sources of such largesse are under fiscal pressures of their own. Only by elevating yields on its Treasury bills will the United States be able to attract interest in its ever-expanding menu of Treasury auctions.

Raising yields on Treasuries will greatly increase the cost of public borrowing, thus adding to the fiscal imbalance confronting Washington. The growing unease regarding the size of the U.S. deficit by both sovereign wealth funds and private investors, and the real possibility that Washington will lose its coveted AAA status, has implications beyond Treasury yields. Policy decisions that address the nation's fiscal imbalance may become essential in order to maintain interest in purchasing U.S. public debt instruments. This would mean budget cuts and tax increases, which would greatly increase the likelihood of a double-dip recession.

Given the track record of the U.S. political establishment, I suspect that they will delay a serious deliberation on the fast-developing fiscal crisis confronting the public finances of the federal budget until it is too late to avoid the most critical consequences. What the recent Treasury auction demonstrated is that Washington may be fast approaching a situation where insufficient demand exists to satisfy the government's appetite for borrowed money. What happens then? The most likely result would be monetization of the debt by the Federal Reserve. In effect, the Fed would conjure money out of thin air, and use this newly printed stack of greenbacks to purchase Treasuries that are left behind by global investors and sovereign wealth funds. Should that unhappy day arrive, you can lay the U.S. dollar to rest, for it will not be worth the paper it is printed on.

Follow Sheldon Filger on Twitter: www.twitter.com/EconomicCrisis

Comments

[bohemiangrooves]

We don't "borrow" money to finance deficit spending in a fiat currency system. The fact that this is being stated by Filger should give you pause when reading any of his analysis. The 'monetization of the debt' is a myth that doesn't even make sense in a fiat currency model with flexible exhange rate systems. The biggest threat to the american economy is a lack of understanding about how the monetary system actually works - that the true measure of the economy is inflation and unemployment and the ability to produce goods and services that the public demands. The debt grows when we deficit spend (not the other way around) because all deficit dollars are translated into private sector savings dollar for dollar, which are then cleared out by govt. bonds for the Fed to maintain its chosen interest rate. The debt (or more accurately the Interest Rate Maintenance Account) is simply a Fed tool used to clear excess bank reserves and deter interbank competion to maintain the interest rate.

[Tekkdude]

If what you say is true, then why is monetization of the debt being taught in Graduate B-Schools?

[joebhed]

Help me out here, bohemia.
First , I totally agree with this statement:
"The biggest threat to the american economy is a lack of understanding about how the monetary system actually works.....".

Having said that, and being a proponent of monetary literacy, I am confused by a couple of things.

"We don't 'borrow' money to finance deficit spending in a fiat currency system."
First, all nations are using a fiat money system, so why mention it?
Second, if "deficit spending" means there is less revenue than expenses budgeted, and the budget is funded, and if we don't "borrow" the deficit money, from where does it come?
Then, there is this -
" The debt grows when we deficit spend (not the other way around)".
ummm, what is the other way around?
Doesn't this suggest that we DO borrow money when we fund the budgets with deficits?

Then, "all deficit dollars are translated into private sector savings dollar for dollar,"
Do you mean that government borrowings, to make up the deficit, displaces private sector borrowing?
Is that what "translated" means?

And, finally, is the overall conclusion here supposed to be that the purpose of deficit spending is the maintenance of any certain interest rate policy of the Fed?
Which is NOT the government.
Or that, this is the RESULT of deficit spending?
That's what I see here.
If so, there's a lot of room on this page for you to connect the many, many missing dots.

Yours for monetary education.

[lightningbolt]

I wonder if the great default is coming soon.

[bohemiangrooves]

the only way a default on US govt bonds can occur is if the US dollar is not used as a currency in the US anymore. The only way this can occur is if the govt. is unable to raise taxes (the only reason currency exists is to settle govt tax owed). This could only happen through massive tax revolt or complete civil breakdown.

[Aaror]

Fun with math:
$10 Trillion (our current debt) times 1 percent is $100 Billion.
A downgrade of US treasuries from AAA to AA would probably lead to at least a 1% increase in interest rates.
A 1% increase in bond interest rates would reduce the value of an existing 5 year bond by 5% (2.59% 5 year bond has a current value of $877.03, 3.59% bond has a current value of $832.92, difference $44.10 divided by 877.03 is 5.02%)
Seeing the value of bond holdings drop 5% would spook many bond holders, leading them to sell bonds. This would reduce the demand for US treasury bills, which would increase the demanded yield.
Rinse and repeat...

[marinara]

As the USA floats more and more of our debt, we can't allow for a weakening of demand for treasuries. As we issue more debt, any softening of the market is very important.

Dinksinger, you also use a bad example. The situation ten years ago is a polar opposite of today's treasury market. You are being disingenuous.

As the administration speeds up the issue of debt, future trends become more and more sensitive.

[bohemiangrooves]

the only reason the administration is issuing more debt is because the larger deficit is translating into more private savings which end up with banks. the fed then needs to clear those excess reserves to maintain interest rates so it issues more bonds. there is nothing magical about this.

[DinkSinger]

I love alarmist posts. Here are the facts.

In the competitive auction of 5-year Treasury Notes whose results were announced today the yields were:
High, 2.689%; Median, 2.590%; Low, 2.000%

Last month's results were:
High, 2.700%; Median, 2.619%; Low, 2.590%

Notice that in every category the yields declined month-to-month. So at this month's 5-year auction the Treasury got a better deal than last month. They may have been "yields far above what had been anticipated", but I'm at a loss to understand why the yields were anticipated to decline.

It is true that there were only about $1.92 in bids for every dollar of Treasury notes offered as opposed to $2.58 last month. This is the decline in the in bid-to-cover ratio that the post mentions. It is a significant decline, but to put it in perspective ten years ago, when we were retiring Treasury debt, the bid-to-cover ratio on five-year notes was 1.88. One interpretation of the decline is that investors are becoming less risk averse as the economy begins to recover and are moving away from the safety of Treasuries.

[joebhed]

Phheeeew !!

Thank goodness.

That quote by O'Donnell WAS raising a few alarms.
And I still have my meager few Thou in ST Treasuries.