Wednesday, March 21, 2012

Peak Imbalances Are Falling

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The topic at hand is the 10-year U.S. Treasury bond, its falling price, and consequent rising yield. The ten year was trading at a 2.03% yield on March 9 and rose to 2.38% on March 19, 2012. These things happen and the ten-year may fall back to a price and yield that satisfies central bankers and Wall Street. Nevertheless, the era of artificially low government bond yields is coming to a close.

There is a simple reason for the new, protracted bear market in bonds, however complicated it is to divine the particulars and time of the unwinding. Starting with animal impulses, the remaining market participants believe that central banks control markets today. On the date it is
recognized the Fed has lost control, yields across the curve - and on corporates, junk, municipals, and stocks - will be adrift, without their bearded anchor.

We have passed the peak of post-Bretton Woods accumulations. Peak Imbalances are falling.

The United States cut the world loose from the International Gold-Dollar Standard on August 15, 1971. Thereafter, international trade and financial balances (obligations among countries and other counterparties) have not settled. Such liberties were not possible prior to President Nixon's repudiation. Now, there is no constraint, other than the parties' willingness or ability to fill other parties' deficiencies. Since obligations never settle, they accumulate. The United States has accumulated a $7.5 trillion current account deficit. (The current account is composed of trade, services, and transfers, but mostly trade)

This deficiency on the part of the U.S. has been most conspicuously filled by the Chinese government's willingness to finance American shoppers' every wish. The PRC's continued willingness is not a question, but China is no longer able to harbor this imbalance.

China produces and America buys. The Chinese have financed American purchases by purchasing U.S. securities, primarily Treasuries and mortgages: we'll ring fence (as the eurocrats like to say) the discussion around U.S. Treasuries. Since the U.S. was buying (importing) more goods than it was selling abroad, China accumulated dollars, year after year. From this pile of dollars, China bought U.S. Treasuries. The recycled dollars financed granite, kitchen countertops and trips to Wally World.

This arrangement has ended. China's Minister of Commerce Chen Deming announced that China will be the world's largest importer in a few years. (
Xinhua, March 18, 2012) We have reached, actually passed, China's peak purchases of U.S. Treasuries. Instead of buying, the Bank of China will need to sell U.S. Treasuries to finance its trade deficit.

The same is true of Japan. It is now an importer rather than an exporter. To pay for goods coming ashore that exceed goods shipped abroad, it will need to sell U.S. Treasuries.

Even as these accumulations roll over, the U.S. Treasury needs to borrow at an increasing rate. In February 2012, the Treasury spent one dollar for every 31 cents it received in revenues (basically, tax receipts).

The post-1971 arrangement described above fostered an accumulation of central planning by central bankers. Today, central bankers are economists. They do not have experience in markets. They consider markets to be a tool for "policymakers," as Federal Reserve Chairman Ben S. Bernanke describes himself. Central bankers opened this pretense of mental perfection by interposing their superior egos into markets. Lately, they have manhandled each and every one of them: government yield curves, stocks, commercial paper, money-market funds, commodities, currencies, credit-default swaps, and houses.

"Houses?" one might ask. Yes, support operations (in the United States) of securities markets are underwritten by the Fed's house market collapse prevention policy. Above all else, the Fed is a Muppet of Too-Big-to-Fail banks. It encouraged the criminal financing of mortgages on the way up, and still props house prices today. The preternatural policymakers would not consider the improbability that they cannot perpetually elevate bond, stock, commodity, currency, and houses, even though their seedy, CDO-mortgage economy came a cropper.

It was not only China that underpriced its currency while overpricing the diminishing value of American credit. Other Asian central banks have operated in a similar fashion. The U.S. current account deficit rose from $114 billion in 1995 to over $800 billion in 2006. To pay for this underproduction of goods and services, the United States borrowed $2 trillion from abroad in the 1990s. Then, the U.S. borrowed another $4 trillion between 2001 and 2010. Recall that borrowing and lending never need be settled under the present dispensation. The $2 trillion in 2000 expanded to $6 trillion by 2010.

China posted a $31.5 billion trade deficit with the rest of the world in February 2012. Exports grew 18.4% to $114.5 billion while imports grew 39.6% to $145.9 billion. Commentators explained that waning exports to a waning Europe caused the deficit. Yet, exports increased 18%. The Chinese New Year and industrial retooling were other explanations. Noted.

Bill King (
The King Report) was probably on the mark when he wrote that China is now importing inflation. This being so, the Bernanke answer to all problems (create money) will exacerbate the Chinese trade deficit.

Japan had a trade deficit in 2011, the first such deficit since 1980. Exports shrank by 2.7% in 2011 and imports rose by 12.0%. Japan is the second largest holder of U.S. Treasury securities, after China. They both hold over $1 trillion of Treasuries. Reasons stated for Japan's falling trade fortunes include the 2011 earthquake and tsunami, falling exports to waning Europe, and its aging population.

The Bank of Japan also faces a new problem of funding the Japanese Government Bond (JGB) market. The Japanese people and companies have been reliable buyers. This will no longer be possible. Even if Japan's trade deficiency is arrested, the Japanese are now spending their accumulated savings.

Another complication is the need to fund the United States' deficit. The United States had accumulated a public debt of $3.8 trillion by 2007. It is expected to reach $11.6 trillion in fiscal year 2012. Foreign central banks hold over $5.5 trillion of U.S. Treasury securities. This is Exhibit #1 of policymaker interference in markets. These holdings demonstrate a blatant manipulation of the Treasury market. What yields might be without central banking policymaking is not known. After it is recognized the Fed has lost control, we may find out.

In February 2012, U.S. Treasury receipts were $103.4 billion and federal spending reached $335.1 billion. The Treasury only received 31 cents for every dollar spent.

In concert with falling trade surpluses, foreign central bank buying of Treasuries has waned. Between August 1, 2010, and July 31, 2011 foreign central banks increased their U.S. Treasury holdings by $381 billion. Since August 1, 2011, their holdings have fallen, not by much, but the behemoth wad of forthcoming Treasury issues requires elephantine buyers that are indifferent to prices: that is, central banks.

The ECB, Bank of England, and Central Bank of Iceland are unlikely candidates. It is possible some U.S. financial institutions can be persuaded to buy with abandon, but there would seem to be a limit. ("There would seem to be": Who knows anymore the limits of crony capitalism?) This leaves the Federal Reserve as buyer of Treasury securities at the same moment they are issued by the Treasury Department. Have no fear: Ben's modeled that.