Thursday, August 27, 2009

The Recent Treasury Auction Brouhaha

In yesterday’s An Introduction to Treasury Auctions, my intent was to provide some background information on Treasury auctions that might be appropriate to get an equity-centric investor up to speed on the basics.

I know from personal experience that it is easy to define one’s investment universe as consisting entirely of stocks, but if we have learned anything in the past year, it is that erecting artificial boundaries to one’s investment knowledge dramatically increases the risk of getting blindsided in any asset class.

So with the introduction out of the way and with the considerable encouragement of a number of readers, let me turn to some interesting recent developments that have created quite a stir in the bond circles.

The issue of foreign demand for U.S. debt has loomed large during the course of the financial crisis. One of the early flash points was the deterioration and eventual government bailout of Fannie Mae and Freddie Mac. At that time, approximately 10% of China’s GDP was invested in bonds issued by Fannie Mae and Freddie Mac, which was probably the reason why Treasury Secretary Henry Paulson felt the need to explain:

Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. [emphasis added]”

As noted yesterday, China and Japan each account for about 1/3 of the U.S. Treasury debt held by foreign nations. Since the beginning of the financial crisis, there have been rumblings that interest in U.S. debt may be waning in the Treasury’s two largest customers – an issue that was summarized nicely by Keith Bradsher of the New York Times at the beginning of the year in China Losing Taste for Debt from U.S. The most recent data available show that China, the largest customer of U.S. Treasury securities, reduced its holdings from $801.5 in May to $776.4 in June.

The issue became a little stickier when the Fed decided to change the manner in which it reports data from indirect bidders on June 1st. In Is Foreign Demand as Solid as It Looks? Min Zeng of the Wall Street Journal claimed that the new reporting standards which expanded the definition of indirect bidders made it more difficult to determine the level of foreign demand.

Skipping ahead to the punch line, the most interesting recent claim of note comes from Chris Martenson, whose The Shell Game – How the Federal Reserve Is Monetizing Debt makes the case that the Federal Reserve is using a custody account to enable foreign central banks to swap agency debt for Treasury debt. If this turns out to be the true, it will undoubtedly have some very interesting implications.

For those seeking out additional background and context, the following will likely be of interest:

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