Friday, September 7, 2012

There is No Treasury Market

It's been rather popular to claim that the low interest rate on USTs proves that "the market" has judged the US government's position re: assets and liabilities as no big deal, therefore Republican whining about the deficit is just that--whining. There are two premises behind that argument. The first is the Efficient Market Hypothesis, which is the claim that the price of an asset reflects the aggregate of the market's total knowledge about an asset. This hypothesis may or may not be true, but it's pretty reasonable. The second premise is that the USTs are in a market. This claim is false, and we're about to see why.

The first problem is due to the existence of central banks. In a free-market system, investment banks have to raise capital by offering yield to clients. The securities they invest in must therefore have a higher yield in order for the bank to profit. The yield offered to clients must be high enough to create an incentive to save, and the yield on securities must be high enough for the bank to earn enough profit to satisfy its shareholders and to cover the borrower's risk of default:

  1. Interest offered by banks rises when people haven't saved very much, and fall when they've saved a lot.
  2. Bond rates rise when entities want to borrow a lot, and fall when they've not got much desire to borrow.
  3. Bond rates must be higher than bank interest for banks to profit.

This process is vitiated by the Fed. Banks don't offer yield to the Fed to obtain savings; the Fed prints money and dictates yield to the banks. As a result a critical component in market interest rates--the desire of savers to save--is outright eliminated. Instead, it works like this:

  1. The Fed sets the discount rate based on macroeconomic policy goals.
  2. Bond rates rise when entities want to borrow a lot, and fall when they've not got much desire to borrow.
  3. Bond rates must be higher than the Fed's discount rate for banks to profit.
This what is known as a "carry trade." All a bank has to do is find an asset with higher yield than the Fed's discount rate in order to profit. And if it can use sufficient leverage, it can obtain just about any imaginable rate of profit, so the rate of inflation ceases to be relevant. Since the US government prints money to pay its debts, that makes a carry trade in Treasury Bonds look mighty attractive.

The second problem is due to regulations requiring certain classes of funds to invest in highly-rated assets. In a free market, which entities get what fraction of the available savings at what interest rate is determined by the investors' assessment of their risk. However, US financial regulations legally obligate certain classes of investors to invest a government-mandated fraction of their funds in assets based on ratings agencies' assessment of their risk. That's why that AAA rating is important--it puts an asset into that special class that things like pension funds are legally required to invest in. Before the bursting of the housing bubble, mortgage-backed securities were a huge chunk of AAA-rated securities. Those are gone. Italian, Spanish, and Greek bonds are off the table, too. Since the USA issues 60% of AAA-rated debt, that forces a lot of investors into bonds that would look elsewhere in a free market, artificially depressing interest rates.

The third problem is what Zero Hedge derisively calls "front-running the Fed." There are two ways to make money from bonds: holding a bond until maturity, and selling it whenever the interest rate drops. For the last several years, Bernanke has announced all kinds of bond-buying schemes. In a market, investors keep their cards close to their chests--you don't announce how much you're going to buy days in advance, or you won't make money. It's a pretty simple technique--the Fed announces it's going to buy quantity of bonds. This will push the interest rate down. All you have to do, then, is buy some bonds right before the Fed does, and sell them to the Fed at a profit. Easy as pie! This demand for bonds isn't being driven by any kind of market phenomena; it's driven entirely by guessing at and then reacting to Bernanke's announcements of how much money the Fed is going to print and then buy bonds with.

So there you have it. There is no bond market to be analyzed with the conventional tools of market analysis. It's entirely a rigged game right now.


Dave said...

Mr. Goldstein,

You forgot to add that all bank demand deposit accounts are effectively on the Fed's balance sheet too - in the case of a major bank run, the FDIC will receive dollars from the Treasury freshly printed from the Fed.

So really retail banks must not worry about losing their deposits because they are the federal government's liability.

Why don't we all just open checking accounts with the Fed? They ultimately hold all the liabilty anyway, so why have all the retail banking middlemen?

Fearsome Pirate said...

I don't understand why anyone has to work when we have a Federal Reserve. It makes no sense!

Dave said...

Sadly, if you accept the truth of my post above, you realize that nearly all lending is government lending.

But of course, all of our problems are to be blamed on rampant capitalism!