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More on the Non-Existent US Government Bond Market Vigilantes

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July 12, 2011 – Comments (8)

Goes in line with a few of my recent posts:

The Phantom Bond Market Vigilantes -- http://caps.fool.com/Blogs/the-phantom-bond-market/611923
What would happen if the US Federal Government stopped issuing bonds? -- http://caps.fool.com/Blogs/what-would-happen-if-the-us/612372
Follow up: What would happen if the US Federal Government stopped issuing bonds? -- http://caps.fool.com/Blogs/follow-up-what-would-happen/612905

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WHO BOUGHT ALL THOSE BONDS?
12 July 2011 by Cullen Roche

http://pragcap.com/who-bought-all-those-bonds

On March 3rd I asked “Who Will Buy The Bonds?”  I wrote this piece in response to a letter by Bill Gross in which he asked:

        “The Treasury issues bonds and the Fed buys them. What could be simpler, and who’s to worry? This Sammy Scheme as I’ve described it in recentOutlooks is as foolproof as Ponzi and Madoff until… until… well, until it isn’t. Because like at the end of a typical chain letter, the legitimate corollary question is – Who will buy Treasuries when the Fed doesn’t?

        …I don’t know. Reserve surplus sovereigns are likely good for their standard $500 billion annually but the banks are now making loans instead of buying Treasuries, and bond funds are not receiving generous inflows like they were as late as November of 2010. Who’s left?”

I responded by explaining that the bond auctions will serve as their usual reserve drain.  This meant that Treasury and Fed would continue to coordinate bond issuance in accordance with reserves in the system.  And the Primary Dealers would execute the reserve drain once QE2 ended.  Just like they always do.   The auctions would move along just as they always have and the mysterious (non-existent) bond vigilantes would appear to be in a deep slumber again.

Well, today we got the first bond auction since the end of QE2.  And what happened?  It was as strong as ever.  The bid to cover came in at 3.22 with the Primary Dealers submitting bids for 2X the entire auction.  Of course, I pointed this same phenomenon out several times before and during QE2, but you still heard the same rumblings today from various skeptics who said that the auction was only strong because of QE3 rumors.  Nonsense.  The auction was strong for the same reason they always are – the reserves are tracked in the system and hoovered up in accordance with the scheme that the mainstream media calls the “funding of the USA”.  Of course, funding is not the purpose of US bond issuance, but explaining a boring old reserve drain wouldn’t make for good TV or political theater.


8 Comments – Post Your Own

#1) On July 12, 2011 at 9:04 PM, dbjella (< 20) wrote:

Who are the primary dealers that bought up the bonds and who do they in turn sell the bonds to?

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#2) On July 12, 2011 at 9:22 PM, binve (< 20) wrote:

dbjella,

>>Who are the primary dealers that bought up the bonds

http://www.newyorkfed.org/markets/pridealers_current.html

>> who do they in turn sell the bonds to?

1) Banks with excess reserves who wish to earn more than 25 bp
2) Secondary dealers and other government securities dealers
3) Add to their own stock so that they can leverage them on the repo market
4) etc., etc.

 

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#3) On July 12, 2011 at 9:29 PM, dbjella (< 20) wrote:

What would happen if #1 stopped buying them, because something better came along?

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#4) On July 12, 2011 at 9:39 PM, binve (< 20) wrote:

dbjella,

Banks have only a few options with what to do with their reserves

1) Leave them sitting in the vault as cash (they normally keep a little to satisfy customer demand)

2) Keep them on account at the Fed (earning only 25 bp, and until recently they earned zero), and this is what most banks do with the amount of reserves necessary to meet reserve requirements (and it is worth noting that many major banking systems besides the US have no reserve requirements at all).

3) Buy US Treasuries

It is absolutely crucial to understand that reserves are not lent out. Banks make loans independent of their reserve positions (see here).

So after a bank manager decides on the level of reserves to maintain for requirements and to peform clearing activities (which are the reserves primary purpose), they can either earn 25 bp, or they can buy a US Government security earning much more. The US Government bond market is by far the biggest and most liquid market on the planet. So if a bank ever needed to liquidate a Government bond they held in exchange for reserves they could do that easily and at any time.

Your hypothetical question has really only one answer, the one I gave above.

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#5) On July 12, 2011 at 10:50 PM, Frankydontfailme (27.51) wrote:

Binve, have you considered the simple truth that US bonds are being purchased due to risk-off/ deflationary fears? This combined with what many believe is a done deal (QE3) would certainly lead investors into treasuries.

Whether there is a QE3 or not.... does it matter? Just the fact that its potentially in play alters the investor sentiment in the bond market. And so it isn't a true free market and so the lack of bond vigilantes seems reasonable... why be a bond short when you could be a dollar short? 

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#6) On July 12, 2011 at 10:54 PM, Frankydontfailme (27.51) wrote:

Also, you seem to be echoing one of the consequences of financial oppression... the banks have no choice but to buy these bonds. In this sense it is a ponzi scheme, interest rates are artificially low and everything is great... until its not.

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#7) On July 13, 2011 at 12:25 AM, binve (< 20) wrote:

Frankydontfailme,

>>have you considered the simple truth that US bonds are being purchased due to risk-off/ deflationary fears?

Perhaps. On the one hand you have Bill Gross, the bond 'king', asking "Who will buy the debt after QE2 ends?". And the answer is 'plenty of people'. So many assume that the bond market will no longer continue to 'fund' the US (even though they do no such thing anymore), and that bond yields will 'skyrocket'. The truth is, the US economic situation is much more like Japan's than anyone else's. They have a debt/GDP much higher than the US and extremely low yields, precisely because there is no 'funding crisis' in Japan just like there is not one in the US. Japan is sovereign issuer of the yen, which is a floating exchange rate currency, just like the US is sovereign issuer of the Dollar. JGB's do not 'fund' the Japanese government, just as Treasuries do not 'fund' the US government.

>>Whether there is a QE3 or not.... does it matter?

Not a single bit. QE3 will be a monetary non-event, just as QE2 was. It did nothing to help the real economy as was just a massive asset swap. (There was all kinds of rhetoric and misperceptions too, because most don't seem to understand QE).

>>Also, you seem to be echoing one of the consequences of financial oppression... the banks have no choice but to buy these bonds

Did you even read what I wrote? Banks have 3 choices. They are absolutely free to not hold Treasuries and can just sit on reserves. There is absolutely nobody forcing a bank manager to buy Government securities with excess reserves.

But if you were a bank manager and you sit on excess reserves earning 25 bp, and don't buy Treasuries which even on the shorter end of the curve earn 50-100 bp, would you even know what you were doing? Banks are getting free money from the government to hold on to their 'debt' (which, again, doesn't fund anything).

This is precisely why I said in this post that the US government should get its head out of its a$$ and just stop issuing bonds. Because they don't fund anything. It is stirring up all kinds of idiotic 'debt ceiling' shennanigans because most people still assume they do actually fund the US. And it is giving 'free money' to the bank (who of all the sectors of the economy need it the least). 

Do away with Government bond issuance altogether. Have the government and Congress start talking facts about our monetary system instead of rhetoric. While we are at it, end the Fed (merge it with the Treasury), since they are redundant institutions (two halves of the same balance sheet).

But none of that is likely to happen, so the same 'debt ceiling' idiotic political posturing will continue every few months/years.

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#8) On July 13, 2011 at 1:12 AM, Frankydontfailme (27.51) wrote:

Yeah. I agree with you on this point. Sorry I don't read everything you write carefully enough.... you write so much and with such detail (but I keep on meaning to read your through your blogs).

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