In my October 18th piece, Too much money, not enough paper, I pointed out that the Fed’s LSAP programs had created an excess of money and a scarcity of interest-bearing assets, a period I’ve jokingly referred to as The Great Incredible Paper Chase for the last year. In that post I mentioned that “debt issuers have done what any rational party would have done when there is more demand than supply of a good they can produce, they've stepped up production.” And that, “As long as the Fed is expanding their balance sheet, the market will have the capacity to absorb new issuance.” Since the onset of the first LSAP program, corporate bond debt has grown by $1,386B (+34.4%) while non-financial business (corporate and non-) excluding corporate bond debt has shrunk by $765B (-5.18%). However, despite this breath-taking corporate debt issuance and record-setting deficits (supply), long-term rates have managed to fall for all four of the years in question thanks to $1,277B in balance sheet expansion by the Fed.
On December 12th, the Fed announced a new LSAP program aimed at replacing Operation Twist 2 in which the Fed will buy $45B in notes and bonds in an attempt to “maintain downward pressure on longer-term interest rates.” For those of you keeping score, that—when combined with the Agency MBS purchases of $40B—amounts to $85B in monthly Fed Balance Sheet expansion, or $1,020B/yr. The actions were pooh-poohed by many a commentator and talking-head that don’t know their Ps from their Ls, many of which, as usual, called for higher rates, in no doubt riding the coat-tails of a certain Westport, CT hedge fund manager who predicted that “at some point” there would be a vast fortune to be made by “someone” by “shorting bonds.” Your not-so-humble correspondent would like to remind you know that said commentators have absolutely no clue how supply and demand actually work and said hedge fund managers are merely trying to scare you into indecision. While it is true that the FOMC’s September 2012 announcement to buy $40B/mo. in Agency MBS has had little effect so far, commentators are ignorant as to prepayment and settlement mechanics of the TBA market which mean that, while the risk has changed hands already, the cash and product are lagging a few weeks behind. But make no mistake, the balance sheet will swell (in fact, it just started doing so ~7wks ago) and once the full effect is felt there will be an increasingly acute shortage of yield-bearing high quality assets. In particular, my calculations indicate there is $87.6B in as-of today unsettled Agency MBS purchases due to settle in the next 8 weeks.
To put the LSAP numbers in context, according to the Federal Reserve’s Z.1 release, the combined private sector, as of the latest reported quarter, is creating debt at a yearly rate of $345B/yr. (+1.08%), of which $481B (+2.54%) can be attributed to non-financial business and -$132B (-1.04%) can be attributed to households ex-student loans owned by the federal government (1). The bulk of household deleveraging took place through mortgage debt reduction (by repayment or cancellation) of $270B (-2.78%) and the bulk of business credit creation took place in the corporate bond market, where bond issuance was an astonishing $426B (+8.55%). The state & local government sector had no significant change in debt issuance, with long-term municipal security issuance remaining relatively unchanged at $3.2B (+0.10%). In that same period, federal debt held by the public increased by $1,142B (+11.27%) and total Agency- and GSE-Backed security liabilities shrank by $41B (-0.54%) despite growth in the mortgage market share, growth which will be difficult to repeat without a TARP-like program open to households with non-Agency backed mortgages. In fact, even though the economy-wide deleveraging has stopped, outside of auto loans, student loans and corporate bonds, deleveraging and net negative security issuance remains an ongoing theme.
At the of this writing, our good-for-nothing legislators still have not managed to produce a budget, which means that I am unable to give you a read on next year’s deficit, but assuming a deficit range of $900B-$1,200B and continued net negative supply in the Agency- and GSE-Backed security markets to the tune of $0 to $40B, it is quite probable that net issuance of (credit) risk-free assets will be either flat or negative in 2013. That is to say, there will be even more money and even less paper ($1,107.6B to be precise; $1,020B in new purchases and $87.6B unsettled Agency MBS purchases). Add to that the approximately $1,500B in accounts currently covered by TAG, much of which I expect to move to T-Bills and other high-quality money market instruments, and it may very well be that the theme of 2013 will be one of a scarcity of high-quality collateral as we face net negative supply and increasing demand, which is something that I urge those of you who do know your Ps from your Ls to consider before going all-in shorting treasuries intoxicated by some fantasy of Soros-esque riches and fame.
- we subtract these so as not to double-count as we consider these to ultimately be public obligations