Thursday, June 28, 2012

John Carney — The Mystery of the US Treasury Market

The US Treasury market continues to baffle.
Despite an almost unfathomable supply of U.S. government debt, yields right across the curve remain at stunningly low levels. It almost seems as if the law of supply and demand has been suspended.
The quest to explain this phenomenon is giving rise to a conspiracy theory of the markets: the Fed is secretly propping up demand for Treasurys by printing dollars....
Viewed in this light, there is no contradiction or mystery at all to falling Treasury yields. Investors are buying the stock of safe assets even faster than the world can produce them....
Getting this right is important for understanding fiscal and monetary policy. We’re living through a great contraction of safe assets, which puts enormous strain on a financial system heavily reliant on collateralized trading between counter-parties. Any program that threatens to reduce, say, the amount of debt issued by the U.S. government should at least take into consideration the likely effects of further contraction.
Read it at CNBC NetNet
The Mystery of the US Treasury Market
by John Carney | Senior Editor

Another good one from John.

UPDATE: Prof. Scott Fullwiler in the comments:
STF said...
Apparently none of these people have heard of arbitrage (and hedging net long/short positions via derivatives), particularly where the dealers are guaranteed liquidity in the repo mkt by the Fed (not to mention CB swaps to stabilize access to offshore funds for non-dealers). And that's all the time, not just now, as Eccles explained. Supply/demand is true, but you have to have the right supply/demand to get the analysis right. So "there's more debt supply so rates should be higher as prices fall unless there's some Fed conspiracy" is applying Econ 101 to a far more complex context.
June 28, 2012 7:03 PM

18 comments:

Pete said...

This statement from the CNBC article is just wrong:

"Joe Weisenthal did a great job Tuesday morning shooting down this idea. As the chart below shows, Treasury yields (represented by the rising red line) have been falling for 30 years, even as the national debt has been rising."

in response to:

"In applying this principle to the logical/financial contradiction of the U.S. Treasury market, I was left with only one possibility: that B.S. Bernanke is secretly (and illegally) counterfeiting U.S. dollars — and using those bogus dollars to prop up the U.S. Treasury market."

The fact that yields have been falling despite the national debt rising, is not an argument that contradicts or refutes the theory that Bernanke is secretly buying Treasuries.

Yields can fall through monetization, alongside the total supply of debt rising.

Dan Kervick said...

Pete, you misunderstood the argument. Wiesenthal didn't say that the fact that yields have have been falling for 30 years "contradicts" the claim that Bernanke is secretly buying treasuries. He simply pointed out that there is no empirical basis for that conspiracy theory, since yields have been falling for three decades while the debt has been increasing. Clearly falling yields on treasuries is economically compatible with a rising supply of treasuries.

Of course, that fact is known to everyone who has taken Economics 101. I was flabbergasted by this comment from Mr. Nielson:

"... the highest prices for U.S. Treasuries at a time of maximum supply. This, in itself, is an absolute financial contradiction. The highest supply in history directly implies the lowest prices in history, for every market in the world — except U.S. Treasuries."

Apparently Nielson has never heard of the laws of supply and demand, since it is obviously not the case that highest ever supply "implies" low prices. Price is not determined by supply alone, but by the interaction of supply and demand. If the demand for some product is rising faster than the supply, prices will go down, even if the supply reaches previously unheard-of level.

By the way, is Nielson aware of the fact that the Fed buys treasuries all the time, as part of their routine open market operations?

STF said...

Apparently none of these people have heard of arbitrage (and hedging net long/short positions via derivatives), particularly where the dealers are guaranteed liquidity in the repo mkt by the Fed (not to mention CB swaps to stabilize access to offshore funds for non-dealers). And that's all the time, not just now, as Eccles explained. Supply/demand is true, but you have to have the right supply/demand to get the analysis right. So "there's more debt supply so rates should be higher as prices fall unless there's some Fed conspiracy" is applying Econ 101 to a far more complex context.

Unforgiven said...

O.T, but Tom, you might want to check this out from Mother Jones. Interactive Map of the Dark Money Universe:

http://www.motherjones.com/politics/2012/06/interactive-chart-super-pac-election-money

wh10 said...

Scott -

It would be a very informative post at NEP for you to discuss these complex finance matters. I would also be curious on your thoughts regarding 'shadow banking' and its similarities and dissimilarities to normal commercial banking from a lending standpoint. 'Shadow banking' banking seems to be all the rage on econoblogs these days - I would be interested in MMT throwing in their 2 cents.

Just some ideas if you need em!

FDO15 said...

Thanks to professor Fullwiler's extensive experience on Wall Street these questions have all been resolved! Thanks for your contribution PROFESSOR.

PS - Have you ever been involved in any sort of arbitrage in your entire life?

Unforgiven said...

I can't believe it! FDO asking for Scott's help!!!

Trixie said...

PS - Have you ever been involved in any sort of arbitrage in your entire life?

I have. And I spent a day mumbling about "maximizing profits" as I was cleaning out my office while "someone" was lecturing me about "public purpose". Or how we didn't contribute enough to the D.C. "effort".

What's your point?

Greg said...

"... the highest prices for U.S. Treasuries at a time of maximum supply"


Maximum supply?

Have we reached "Peak Treasuries"?

Matt Franko said...

As for long term trend you have Japan as an example...

As for the Fed's short term effects Mike went over that here a while back, the Fed (monopolist), acting in conjunction with the debt doomsday morons, has been lowering bond prices thru these UST purchase programs:

http://mikenormaneconomics.blogspot.com/2010/12/is-feds-qe2-leading-bond-prices-down.html

This latest ($200B+) extension of 'Twist' will put downward pressure on the bonds short term... ie rally probably "on hold" for now.

rsp

Ramanan said...

I really wonder what arbitrage Scott is talking of.

A trade on the yield curve - such as a steepener or flattener is a bet. An explicit one. (i.e, there is a minor amount of hedging the movement of a parallel shift of the whole yield curve, but nontheless the whole trade is a bet).

A trade such as long Treasury short futures can be thought of as arbitrage if the difference is high, but there are other risks nonetheless. This, however has nothing to do with the low yields at the long end of the curve.

Suppose the long end such as 10y starts increasing suddenly, both (underlying and the derivative) start moving in the same direction.

I have seen Scott mentioning in WCI that this supposedly explains the yields in the long end, which is not right.

The best is to construct the supposed Arb trade.

There is arbitrage but it has nothing to do with the discussions here really.

Mike Norman said...

That chart was here on MNE long before Wiesenthal put it on Business Insider.

Take a look: here

In addition, the law of supply and demand has NOT been repealed. Treasuries are dollars, so you have a lot of dollars, the rate to borrow them is low.

If the government just kept issuing dollars/Treasuries, rates would be zero. The Fed has to even work to keep the rate positive. It's all been explained here a million times and in my videos.

Mike Norman said...

Carney could have wrote about my post on June 12.

STF said...

Hi Ramanan,

It's about the cost of refinancing. Dealers can always refinance in repo mkts. Banks in fed funds. Others in LIBOR. And the Fed stands ready to make sure of this, even as they dropped the ball in 2008 for some time. It's very easy to hedge against movements in these. Yes, there are complications such as the fact that most of these folks don't want to hold to maturity, convexity, etc., but mostly it's about the path of the short rate since it is the refinancing rate (and the complications can be hedged against, too).

Pete said...

Dan Kervick:

Wiesenthal didn't say that the fact that yields have have been falling for 30 years "contradicts" the claim that Bernanke is secretly buying treasuries. He simply pointed out that there is no empirical basis for that conspiracy theory, since yields have been falling for three decades while the debt has been increasing.

Dan, Wiesenthal's argument was presented as a "shooting down" of the Bernanke is secretly buying Treasuries idea. That to me means some sort of refutation, a contradiction, and not a mere "It might not be right because the empirical data does not conclusively show it as yields have been falling for decades."

If maybe he said something like "The secret buying of Treasuries idea may be true, but I should like to remind people that we should consider this idea in a context of yields having already been on a decades long decline", then I would not have said anything.

I do not consider the historical decades long trend of yields falling to be information that "shoots down" the secret Treasury buying idea. For it is possible that the decades long trend of yields declining MAY have otherwise reversed and shot up substantially, had it not been for Bernanke secretly buying Treasuries. In other words, it is possible for history to be one where there would have been an increase in yields even after decades of a secular decline, but because Bernanke is secretly buying Treasuries, that history never took place, and we ended up living in a history that LOOKS like just another addition to a long term trend decline in yields.

Clearly falling yields on treasuries is economically compatible with a rising supply of treasuries.

Of course, that fact is known to everyone who has taken Economics 101. I was flabbergasted by this comment from Mr. Nielson:

"... the highest prices for U.S. Treasuries at a time of maximum supply. This, in itself, is an absolute financial contradiction. The highest supply in history directly implies the lowest prices in history, for every market in the world — except U.S. Treasuries."

Yes, I cringed at that too, but I can see why he would think that. In a world where the money supply and spending on X is fixed, then yes, a rising supply would imply a falling price of X. But we live in a world where the money supply and spending on X can continually overtake the increase supply of X, resulting in an increase in the price of X.

Apparently Nielson has never heard of the laws of supply and demand, since it is obviously not the case that highest ever supply "implies" low prices. Price is not determined by supply alone, but by the interaction of supply and demand. If the demand for some product is rising faster than the supply, prices will go down, even if the supply reaches previously unheard-of level.

Agreed.

By the way, is Nielson aware of the fact that the Fed buys treasuries all the time, as part of their routine open market operations?

Probably, but I think the better question to ask is whether Nielson is aware of the implications of the Fed buying Treasuries, to the money supply, spending and demand, and thus prices.

FDO15 said...

STF, your emphasis on the refinancing effect is way overstated. You've obviously never been on a trading floor to see the volumes that are actually turned over in various segments here.

Ramanan said...

Scott,

A strategy to borrow short and lend long is not the best strategy. Just because the long end of curve is higher than the short end (typically the shape of the yield curve) doesn't mean that this will pay off.

Dealers are intermediaries. They have inventories which they wish to load to the markets in the week subsequent to the auctions and they make money by the general subsequent rise in the following week. They may hedge some of their positions with futures but can't for all because in that case their business is not profitable at all. Their game is not an arbitrage. It's a risky game which pays off.

Finally they have to offload their positions. And for the general market, it is not an arbitrage at all.

The whole market doesn't borrow short and lend long.

Other plays may arbitrage in the Treasuries/Futures. But even in equities they do that. It says nothing about how the equity prices will move.

Matt Franko said...

Ram,

"They may hedge some of their positions with futures"

But dont they (PDs) all also own a commodities brokerage?

So they in effect lay off the risk of a price decrease onto a client of their commodities brokerage that buys the futures contract that they sell?

rsp