The Fate of US Treasuries: Be Careful Betting On the Demise of America

The near disaster of the recent attempt to sell $16 billion of 30 Year Treasuries was a wake-up call; yields popped from 4.54% to 4.70% within twenty four-hours of the news coming in. So was that the sign for the start of the death rattle of the latest of a long line of comic-tragedy experiments with fiat currency?

Plenty of people think so. I thought so last September, then in November and December all the banks all started to say yields on the 30 are going to go to sky-rocket to as much as 7% by the end of 2010. Now, the cherry on the cake, Nassim Taleb of Black Swan fame recently broke with his rule, “I never make predictions”, and joined the herd, and declared that shorting America is the next great play.

It’s pretty obvious really. The American government is committed to selling a lot more debt, so supply is going up; the buyers (particularly foreigners) are saying:

“We don’t want to pay the price you are selling at, and also we have this sneaky feeling you are going to fall off your bike soon”.

Supply and demand – that’s Adam Smith or someone isn’t it? Even a simple-minded cattle herder knows that one; turn up to the market with your cow and the place is swimming with cows, you get that sinking feeling that something has to give.

Every fiat currency is like a drunk on a bicycle, it needs momentum to keep going, and it wobbles, and every one will have its day of reckoning, at least that’s what happened in the past.

But be careful placing a bet on when it’s going to fall off. In case you didn’t notice there has been a game-changer recently, all the cards got thrown in the air, and it’s hard to figure out where they will land.

For most of my life, the way to make money was to borrow. If you had a business or a roject, that’s how you turned 12% IRR into 20%, and if there was inflation, so much the better, and the more you could borrow the more you could make.

I have fond memories sitting up all night in front of the Excel sheet polishing the drivers on the model for some fifteen year prediction or another. You’d save the number you put in on inflation until last and there was hardly a project in the world that couldn’t be “rescued” by nudging the inflation number up; that number was always the easiest thing to sell to the punters, or the bankers, or the rating agencies.

That’s changed, and it’s hard to know what’s going to take its place; those days when you worked out your LTV going forwards you just looked up the yield; there was never any debate on that. Now you have to think and tell a story; and the bankers and the rating agencies woke up finally.

Same thing for “Ordinary Joe”, over the past twenty years in USA it made sense for consumers to borrow as much as they could because (a) thanks to this program or that program the interest was often tax-deductable so that was just a gift from Uncle Sam, it wasn’t perceived as a “cost” (b) because you could borrow at less than the rate of inflation in some assets (houses for example) so you could make money for nothing. And the more you could borrow, the richer you could become, so long as you were sensible (better to borrow to buy a house than a Corvette (then)).

That’s changed too, but the cards are still in the air. It’s still not clear whether that “system” of easy-money is coming back, or if that game is over for ever and ever.

There is another reason people borrow, and that’s either to buy the time to dig themselves out of a hole, or to delay the inevitable. Going broke is all about cash flow and people doing that borrow most from wherever they can and pay higher and higher interest rates. Then one day even the pay-day lender won’t give you any more; and that’s it, game over.

In those situations, if you are country with your very own currency you have the option of debasing it, you can do that with gold (the Romans did), but with a fiat currency it’s even easier, you just print.

That’s what happens when desperation hits.

Rule [1]: Be careful trying to read the psychology of desperate people.

Everyone thought that Saddam Hussein had a bomb. He hinted to everyone that he did, and based on past performance it was obvious that he would have put all his efforts into building one and then dropping it on someone.

That was so obvious that America spent $1 trillion so far to make sure that he didn’t do what it was obvious to everyone that he would most certainly do. Some people say that adventure into mind-reading will have cost the American taxpayers $3 trillion by the time it’s over. I’d like to remark that I don’t want to sound ungrateful that America is keeping the world “safe” (although personally I would have been happier if they had gone after Mugabe first (he makes Saddam Hussein look like a choirboy)), but I can’t help wondering if that money might have been better spent to help dig the fiat currency out of its hole?

Particularly since all they found was a twenty-year old gas mask and a contraption that looked like high-school project to build a drone, and the master of the almost invincible “Axis of Evil” hiding in a hole. And when they asked him why, he let it go that he’d just been spinning a tale to frighten the Iranians.

But then again, that’s one of the reasons fiat currencies were invented, to go to war, the time they really took off apart from in ancient history was to finance the First World War. Imagine, that might have never happened if it hadn’t been for the ability of the protagonists to print money to buy bombs, and gas etc.

The question now is does Helicopter Ben Bernanke have a bomb, and if he does, will he use it? But be careful how you read his mind (refer to Rule [1]).

Don’t forget that from 1998 to 2008 the American shadow banking industry created $20 trillion of debt, independently of what the Fed was doing or the “needs” of the US Treasury. During that time about $4 trillion of government debt was created, which compared to the shadow banking system, was peanuts.

And there was demand, boy was there demand. You could hardly package that stuff up before if flew off the shelf; soon no one really bothered to look inside the box so long as it had AAA stamped on it. Like an automated assembly line filling up twenty-foot containers with boxes of melamine-tainted milk.

And what happened next?

You guessed it; someone opened one of the boxes. That’s what happened

Then what happened was it became blindingly obvious that the Master’s of America’s financial universe didn’t have a clue what to do next.  Hank Paulson is in the news these days explaining how he saved America, and perhaps the world; but he didn’t explain what he was thinking when in July 2008 he declared “The American Banking System is a Safe and Sound One”.

Event’s that followed proved that statement was completely untrue, but I don’t think he was lying. I think he didn’t have a clue what was really going on, and so he and everyone else just did what comes naturally, particularly to Americans, they threw money at the problem. Lots of it.

So here we are eighteen months later and Armageddon was avoided, WHEW!

The difference now is that in 2007 the masters of the financial system were pretty confident that they knew what was going on, and they weren’t shy about telling people that either. Now it’s pretty obvious that they didn’t, but if you think that suddenly there has been a revelation like a big flash of light, and suddenly the “masters” have twigged what’s really going on, well you are welcome to your opinion.

Do I know what’s going on?

I haven’t  got a clue, there are so many things I don’t understand, it’s a long list, for example, (a) what price did the Fed pay for those trillion dollars of toxic debt that magically appeared on their books (b) how much of the 24% direct bidders on the recent auction was the Fed (c) how much will people who own that $20 trillion of debt that the shadow banking system manufactured be able to sell it for, this time next year, in five years time (d) what it’s valued at on their books (e) I don’t even know if you can hold that lovely AAA stuff with a 20% risk weighting when you work out your capital adequacy. I think the answers to those questions are all classified as, “National Security.

Do I have a solution? Not really, although I do think that if people bothered to do proper valuations of their assets using some sort of approximation of International Valuation Standards, they (and people who are exposed to them) would have a better idea about what’s going on, but that’s just my opinion.

Apart from that, I do tend to agree with Mr. Volker who does appear to understand what’s going on a lot better than many people, that in principle it’s not a good idea for governments to hand out taxpayer’s money so some (lucky) people can gamble with it, particularly if it was handed out on the basis that if they lose they don’t have to pay the money back. But that’s just my opinion too.

So my impression is that the ship is sort-of getting steered in some sort of direction, although it’s hard to tell how much the wind and the currents are actually determining what that direction is, or even whether or not the steering wheel (or whatever you call it) is actually connected to the rudder.

But insofar as the yield on the 30 Year is concerned I have the following observations.

1: Before all this happened there was an almost insatiable demand for AAA paper, over $2 trillion a year, so what happened to that? Pension funds and insurance companies are still getting the premiums and the contributions flooding in, and they still need to hold some of their assets in AAA paper, by Law. OK the regulators have been very “understanding” about the valuation of what was once called AAA paper and is now called “toxic” (or to be polite “legacy”), but they still need to buy.

And if they are aiming at some time in the future to face the reality of what all that AAA toxic junk that is clogging up their gullets is actually worth, that’s if they didn’t manage to palm it off on the Fed at who knows what price, they are going to need to stock up on some new stuff. And OK there are questions about the AAA rating of  US Treasuries, but that’s a shell game, because regardless of the quality, so long as the regulators continue to call it AAA, they can comply with the Law.

And no one (yet) is saying that an AAA US Treasury is not worth more than an AAA sub-prime residential mortgaged backed security. How much more no one knows, they used to work that out from the CDS spread but no one is selling those anymore.

2: Looking at the macro-economics which is something that I admit I never bothered to learn much about, and given that the current consensus is that much of what was taught in economics over the past twenty years was rubbish, I’m pleased I didn’t fill up my rather limited brain with that knowledge; although I have made a promise to myself that if ever I find two economists that agree about anything I will make an effort to get up to speed.

But big picture, the best predictor of the 30 Year yield is NOT actually inflation whether you measure it the way the US Bureau of Labour measures it, or the way Shadow-Stats measures it, or even something in between.

And that’s either lagged, or today, or in the future.

By the way I looked at the future as an explanatory variable to test the notion that perhaps economists could actually predict what inflation would be with any confidence. Although that’s a bit of a stretch since they seem incapable of predicting anything more complicated than where and when the sun is going to come up in the morning, and I wouldn’t be surprised if they had a debate about that too.

Anyway, I know that the world and his brother was screaming that when Ben helicoptered all that money into the banks so they could “earn” their way out of trouble (borrowing at 0% and then lending that money to the Treasury at 3.5%), there would be massive hyper-inflation. At least that’s what they were doing six months ago.

Well there wasn’t because very little of that money got out of the closed circuit of Wall Street. So sadly the prospect of serious inflation going forwards is not quite on the table (in my opinion).

But what really drives the yield on the 30 Year is nominal GDP growth, and although I don’t have a really good idea why that is, (and I care less), historically that’s by far the best predictor.

Well, OK nominal GDP ticked up a bit, and so did the yields on the 30 Year. But I wouldn’t bet on that hitting double digits any-time this century.

And if you think of it like that, if you bet that 30 Year yields are going to go up because America’s fiat currency is in its final death rattle, that’s not consistent with the idea that nominal GDP is going to go up.

My opinion, everything is not necessarily as it seems, and my view, for what it’s worth, is be careful if you want to jump in on the sure-fire trade of betting on America’s demise.