It’s Always About The Treasury Flows

We have looked at the central bank holdings — both the Fed and foreign central banks — of marketable Treasury bills, notes, and bonds over the past twenty years and were quite surprised by our findings.   Our analysis may also help explain the mess now taking place in the money markets, which is taking massive Fed intervention to stabilize.

The above table of data illustrate the Fed and foreign central banks held almost 50 percent of the Treasury bills outstanding up until the Great Financial Crisis (GFC) and now hold only 13.81 percent of marketable bills as of October 2019.  Note the October data does not include Fed repo but only bills held outright in its SOMA portfolio and financed by an increase in reserves.

It also was surprising that even with the massive expansion of the Fed’s balance sheet during the QEs, their ownership of the outstanding marketable notes and bonds only increased from around 15 percent to 22 percent.   It does make sense considering threre was a corresponding massive increase in Treasury debt issuance during the past ten years.

Our September 2018 Post

We wrote a huge post on the structural changes taking place in the Treasury market in September 2018,  The Gathering Storm In The Treasury Market 2.0, warning there would be huge natural upward pressure on interest rates given these changes and/or the markets would come under pressure from the increased market supply risking “crowding out” of other markets.

Soon thereafter 10-year Treasury yields broke out crashing the stock market with the S&P falling 20 percent in just a little over two months.

In no way was the Fed “too tight”in a monetary sense in Q4 2018, in our opinion, with real interest rates still close to, or below zero.    The market just couldn’t handle the massive new supply of debt caused by the combination of a growing budget deficit and the Treasury having to refinance the maturities coming due in the Fed’s SOMA portfolio.

Consequently, the stock market crashed bringing in haven flows and short sellers using Treasuries as proxy stock short driving rates lower and the Fed eventually capitulating to the market and political pressure.

Marketable Debt Growing Faster Than Total Debt

One of the structural changes we flagged was that the Treasury could no longer rely on the Social Security surplus to fund itself as it now has moved into an annual deficit.  The added supply would put significant pressure on market.  The debt table above illustrates how the Treasury is becoming increasingly more reliant on market financing for its growing obligations.

The data show that even though the total public debt has grown 228.79 percent since 2003,  debt issuance to the markets has increased at a 50 percent faster clip, increasing by 361.91 percent, compared to 83.72 percent in nominal GDP.

It is absolutely clear, at least to us, especially given that interest rates cannot increase to their equilibrium and market clearing levels without crashing the markets (think Q4 2018) due to the sheer size of the total stock of debt outstanding, market disequilibria will always show up in unexpected places, such as in the cash markets.  The Fed is not only the lender of the last resort and is now called upon to plug the financing gap so the markets don’t blow up.  In a non-reserve currency this would be very inflationary and takes us back to our days as an economist following the Latin American high inflation economies.

Banking System 

Much has been written about the lack of reserves in the banking system, which is not allowing for a natural arbitrage between the Fed funds and repo market.  Our priors were there was a distribution problem with excess reserves, where a few banks owned most of the reserves, which now appears to have been confirmed.    Nevertheless, we are not experts in this area and will leave it to others to explain.

Structural Fix In Money Markets? 

To get back to a level where central banks hold 44 percent of the T-Bill stock as they did before the GFC, the Fed would have to take down another $750 billion of  T-Bills into their SOMA portfolio funding it with an increase in bank reserves.   The fact foreign central banks have reduced their proportional holdings of bills,  from 19.8 percent in 2007 to 11.7 percent in October,  this puts added pressure on the Fed.   Note also,  the Fed moved from holding T-Bills in their SOMA account after the GFC, when monetary policy began to focus on asset purchases and managing the yield curve.   We have a call into the NY Fed to get a better handle on this.

We don’t know, nor does anyone else, but maybe this could what it takes for a structural fix to the money markets but then we suspect there will be large unintended consequences, such a complicating an already dangerous asset bubble and potentially wreaking havoc in the FX markets.

Also interesting in the debt level table is the growth of T-Bill issuance since 2016 has doubled the growth of marketable debt.

Foreign Inflows Into The Treasury Market

Annual private foreign flows into the Treasury market have already reached all-time at the end of October due to a positive U.S. interest rate differential and negative yielding debt abroad.  Nonetheless, the foreign holdings of the total stock of marketable Treasuries has fallen from a high of 53.1 percent to 41.1 percent in October.   The proportion of China and Japan’s holdings of the marketable Treasuries has also declined significantly as their inflows (China flows are negative this year) has been outpaced by the growth of the market debt stock.

Central Bank Holdings Of T-Bills And Coupon Curve

The Fed and foreign central banks still hold almost 50 percent of the U.S. coupon curve though central bank proportional holdings of T-Bills has fallen off precipitously, which is probably why the Fed is engaged in a fast and furious exercise to provide liquidity to the money markets.   We’re not certain about this but it is our best calculate guess.

It would be interesting to add the Fed’s current repo holdings to the last data point in the blue line.  It does include recent purchases of T-Bill by Fed in its SOMA portfolio, however.

In the following chart, it is easy to see why the S&P crashed in Q4 2018 due to a crowding out effect, not so much from interest rates but that liquidity was sucked up and hoovered into the Treasury market.   In 2018, marketable Treasury securities increased by $1.1 trillion and all of it, and then some was financed by non central bank domestic sources.

At the end of October 2019, the Treasury has issued $896 in marketable debt with around 50 percent financed domestically, which does not include the recent multiple rounds of repo operations by the Fed.

S&P Returns And Treasury Issuance

Finally, though the data is very noisy and there are many factors at play, we show in the graph below there is a negative correlation (ρ = -.22)  with returns on the S&P and domestic financing of the marketable Treasury issuance.  The data makes sense and we suspect digging deeper and adding more observations the actual correlation is much higher.

Keep It On Your Radar

Though policymakers and market wonks have completely ignored the debt, deficit, and this type of analysis, we think you should keep it on your radar, folks.  We have zero doubt it will come back to bite the markets in the ass someday.

In fact, Alan Greenspan was out today warning,

See here for full article.

Data Appendix