The week-long Treasury auction of $75 billion of new paper came off pretty well. This is significant because the Treasury needs to finance a record deficit. It’s tricky stuff.
The three-year auction that started Tuesday went well, as buyers such as the Chinese are shortening the term of their Treasury portfolio, so there was strong demand. On the same day the Treasury announced it was increasing the amount of TIPs (Treasury Inflation Protected bonds) it would sell.
On Wednesday, the auction of 10-year notes was just “OK,” but the sale occurred right before the Fed Open Market Committee report on the economy came out. That report said that the economy is “leveling out” and that inflation expectations were low because of the “output gap.”
Then Thursday’s most anticipated auction of 30-year bonds came off without a hitch, considering data came out about retail sales falling and jobless claims going up. The Fed’s expectation of low inflation helped the market. And, apparently foreign demand was good for this paper. No new auctions will occur until the end of August.
Several things struck me about these auctions. First, the promise of more TIPs sweetened the pie for the Chinese and Japanese who hold the largest amount of U.S. Treasuries. It was kind of a bribe: “Look, you’ve got no real other choice than to buy our paper, but, to be nice and to get you to stop saber-rattling about diversifying out of Treasuries, we’ll give you some nice inflation-protected paper. Feel better now?”
Second, the Treasury’s timing is just right. We should see an improved Q3 — or at least this is the most prevalent expectation of most market analysts — and this should take the pressure off of inflation expectations as the economy firms up a bit (but watch out for Q4). In fact the Fed feels so confident that it is tapering off its $300 billion purchase of Treasury paper it started in March to keep interest rates down. It is about three-quarters of the way through this program. The Fed feels the market for Treasuries will strengthen enough to finance the deficit. This sends a signal to foreign buyers that perhaps the dollar has bottomed. Investors believe what the Fed is saying about “exit strategy.” Dollar rally?
Third, they just don’t get the output gap thing. Most Keynesians and econometricians of all stripes say you can’t have inflation if productivity is low and there is a lot of unused capacity. I would question that assumption and ask them to remember the 1970s when we had stagflation. The economy stagnated and we still had high inflation. Why, because inflation has to do only with the amount of dollars the Fed pumps into the system: more dollars than there is demand for them, which means dollars go down in value relative to the price of goods they buy. It has nothing to do with supply and demand for goods. We have a lurking problem with inflation because the Fed has pumped an unprecedented amount into the banking and financial system. While deleveraging continues and asset prices continue to fall, that won’t last forever and inflation will emerge as banks start lending again. I don’t really buy the exit strategy.
Fourth, how much of the 30-year bonds did the Fed or the Treasury buy? These are the most difficult bonds to sell because the longer term makes them more exposed to inflation, which would devalue them over the years (unless you buy TIPs). It came out that in the July auction, the Fed bought almost one-half of the offered seven-year paper, propping up a weak market for the offering and, in effect, monetizing the debt. Sorry, but I’m a skeptic. I just can’t believe that the deficit won’t drive up interest rates.
— Jeff Harding is a principal of Montecito Realty Investors LLC. A student of economics, he has a strong affinity for free-market economics. This commentary originally appeared on his blog, The Daily Capitalist.