What Happens if a Treasury Auction Fails?

It seems that most people do not understand how our government funds its budget deficits. Since we don’t have enough revenue (taxes) to pay for all of our expenses (Social Security, defense, Medicare, etc.), the government must borrow the extra money by selling bonds to investors. Investors buy U.S. Treasury Bonds from our government with yields of around 4% (for 10 year bonds) and our Government gets the money it needs to fund its deficits.

The government sells these bonds at auction. Investors bid for the bonds – and the government chooses the winning bidders. In recent months, we’ve seen yields drop and prices rise as more and more investors buy Treasury Bonds because they are considered some of the most risk free investments on the planet – since they are backed by the U.S. Government. Investors include individuals, institutions and foreign governments – to name a few.

With the economic problems in the U.S. – there is a growing fear that our government will someday hold a Treasury auction – and there will not be enough buyers. If you were a foreign nation (or any investor) and took a hard look at the finances of the U.S. – and could see that we are insolvent and that our economy is heading south – you can see that this is an entirely plausible scenario. The fear is that the Government will eventually go bankrupt – and unable to pay its debts. This would obviously cause us all kinds of unpleasant problems – including skyrocketing interest rates as the Government offers higher and higher yields to get the money it needs.

The dialog below is taken from a forum on Chris Martenson’s website. Chris explains what we could expect if an auction did fail.

I have a suspicion that Chris is right when he says it’s possible the Federal Reserve is the ‘buyer of last resort’ for recent auctions. This means that auctions are already failing – but the Fed is disguising this problem by buying the Treasury Bonds themselves. As Chris mentions below – this is a serious problem. Why? Because the Fed doesn’t have existing money to buy with – they create money. They would be printing money and giving it directly to the U.S. (this would be a similar process to the U.S. needing hard currency – but on a much bigger scale) – which could eventually lead to the destruction of our currency (see Zimbabwe: inflation hit 11.2 million percent in August 2008). Let me put this in perspective – a loaf of bread cost over one trillion Zimbabwe dollars in August. Anyway – you get the picture – runaway interest rates, runaway inflation – very bad things happening.

The following graph shows the assets of the Federal Reserve. The blue line is labeled ‘other assets’ – this is the asset category Chris references below. We don’t know what ‘other assets’ refers to – yet.

There are a lot of bad economic scenarios playing out right now that just about everyone thought would never happen – but they are happening. I believe this is going to be another one.

jg – Nov 12, 2008
_________________________

Recent Forum postings:

First this question from LemonyYellowSchwin on the subscriber forum:

Chris, I assume you still agree that there is still a risk of what amounts to an "auction failure" of US govt. bonds? If so, I'm wondering if you could sort of help us play it out in our minds:

Is this a possibility you put on the near-middle-long term horizon?

What would be the warning signs?

What would it look like?

What would be the consequences and how quickly/slowly would we see it play out?

Thank you so much!

My Response (Chris Martenson):

Great question.

This is exactly in line with the piece I am writing for the next Martenson Report.

Sooner or later (and I am starting to think 'sooner' at the rate things are hustling along) that there will be an auction failure.

The warning signs are simple enough.

The "Bid to Cover" ratio slides down in danger territory (below 2:1). This ratio measures the amount of bids that are received at auction for whatever bolus of Treasuries are being offered at that auction. At 1:1 there are exactly as many bids as there are bonds being sold, but trouble starts well before then. Remember, this is an auction where bids are placed on the bonds. So let's imagine the Treasury is offering a bunch of 10 year notes at 4%. Some eager participants might bid 3.95% (over asking price) while others may bid 4.25% (below asking price). The government will, naturally, select the best possible bids and chuck the rest. By the time we get to 1:1 on the offers it is a near certainty that the bids are going to be at worse prices than hoped. So the first warning sign is a falling bid-to-cover ratio.

Along with this, everybody is keeping a careful eye on the spread between the offered rate and the actual rate. A slipping yield means the government is not getting its desired price for the offered debt and is a sign of either reduced demand (as also reflected by a falling bid-to-cover ratio) or reduced availability of money for the amount of debt being offered (falling supply of money). So the second warning sign would be auction yields slipping higher and higher.

The final part of this act is an actual failed auction where the bid-to-cover ratio falls below 1. That is, fewer bids are received in total than there were bonds offered. An example would be $800 million in bids received for $1 billion in bonds offered. That is a failed auction.

At that moment all hell breaks loose. The government cannot afford a failed auction because it needs the money. So it will simply offer the bonds again at a higher, more attractive yield and will keep raising the yields until it attracts enough bids. The impact of an auction failure will be rapidly rising interest rates.
But once that dynamic starts the incentive is there for market participants to "wait and see" if even more attractive yields are in the offing which can start a spiral of higher and higher rates.

This is why I am so anxious to find out what is on the Federal Reserve balance sheet. I want to put to rest my uncomfortable suspicion that they've already been the "buyer of last resort" at the past few Treasury auctions.

Once a central bank begins making up for funding shortfalls by printing money directly in exchange for government bonds then you are well on the way to destroying the value of the resident currency. Think Zimbabwe and you get the idea.

Given the fact that the Fed is refusing to let anybody see exactly how and where it applied that $1.2 trillion over the past 6 weeks, and given the fact that the US government is on track to issue more new debt this quarter than all last year COMBINED, and given the fact that banks are apparently out of capital, I am wondering how it is possible that each auction has managed to go off without a hitch.

Fueling this concern of mine is that fact that the Treasury International Capital (TIC) flows have shown a steady erosion of foreign money from our shores over the past 2 months reported (July and August, so we are anxiously awaiting the September data).
IN summary, no money from overseas, impaired capital on our own shores, record government debt issuances and a Fed that is suddenly quite shy about revealing its recent purchases.

As I said, it makes me very suspicious that the Fed is directly buying those securities themselves. If true, this is explosive news and could serve to severely undermine faith in the Federal Reserve Note, a.k.a. "the dollar", and so I completely understand why that information would be hidden if it existed.

If I were doing this (meaning I was the Fed), I would want to hide my tracks to every extent possible. One way to do that would be to crush commodities as hard as possible and work with my foreign CB friends to assure the dollar looked strong. This would serve to help convince market participants that direct monetization of government debt was not being done because, if it were, the exact opposite would happen.

More later...

More Intentional Misdirection

You have read numerous posts on this blog relating to how our government manipulates economic data – in order to ‘spin’ the data to show more positive trends. We’re now seeing the same thing with U.S. Treasury auctions.

In the article below by Karl Denninger – you’ll notice that the U.S. Treasury made a significant change in the way it accounts for indirect Treasury Bond bids on June 1st, 2009. Until June 1st, foreign purchases of Treasury bonds were classified as indirect bids – so that investors could accurately evaluate foreign demand. Since the U.S. depends heavily on foreign purchases of Treasury bonds – it’s easy to see that this is an important metric for Treasury bond investors.

Now – additional types of buyers are classified as indirect bids – making it impossible to evaluate if foreign demand for Treasurys is declining. Based on the deceptive way in which this change was made (no mainstream media articles that I can find) – I’m guessing that his change was made because foreign purchases are declining rapidly.

Once again – we see our leaders using deceptive means to disguise the truth of what is happening.

jg – July 5, 2009
_______________________________________

More Intentional Misdirection

Thursday, June 25. 2009

Posted by Karl Denninger in Bonds at 08:38

About a week ago I wrote a Ticker about my astonishment that foreign central banks would want 50% of a 30 year Treasury issue, and mused that these foreigners must be expecting (and might be intending to impose) crushing deflation.

It turns out that my skepticism was well-warranted, for a different reason:

But in a little-noticed switch on June 1, the Treasury changed the way it accounts for indirect bids, putting more buyers under that umbrella and boosting the portion of recent Treasury sales that the market perceived were being bought by foreigners.

The new definitions are deep in the arcane world of Treasury auctions. The change involves buyers who place orders through primary dealers. Those had been counted as direct buyers, but as of June 1 they were classified as indirect buyers, making that group larger than before.

Because investors view that group as being dominated by foreign buyers, they assumed foreign demand was higher.

Very nice.

So now we have the Treasury Department changing the rules so that the investing public cannot determine what sort of actual appetite foreigners have for our Treasury Debt by obscuring what had, up until then, been a very reliable gauge of their sentiment.

This sort of intentional game-playing is obscene and pervasive in our financial system and government over the last twenty years, with this being just the latest insult.

Treasury, of course, knows the interest level of foreigners in our government debt.

Why are they suddenly afraid of letting every market participant see the same information?

Do we have a "little problem" here that someone doesn't want to talk about?

Treasury Auction Schedule

This could be a very interesting week…….

jg – July 26, 2009
___________________________
Treasury Auction Schedule

By: Karl Denninger

June 23rd, 2009

Oh My......

Let's see if I can count this up....

70 day CMBs, $30 billion (tomorrow)13 week Bills, $32 billion (July 27th)26 week Bills, $31 billion (July 27th)52 week Bills, $27 billion (July 28th)2 year Notes, $42 billion (July 28th)5 year Notes, $39 billion (July 29th)7 year Notes, $28 billion (July 30th)19 year, 6 month TIPS (reopened), $6 billion (July 27th)

That's two hundred thirty-five billion dollars over the next week!

Almost one quarter of a trillion.......

I guess you should get while the getting is good, but this is going totally parabolic. That money has to come out of somewhere, by the way, in order for the sale to succeed, which is going to get rather interesting at some point - but exactly where it matters is impossible to know.

I expected that when we crossed the $100 billion threshold in a week the market would throw up all over it, but it didn't. Now we've got the government trying to sell a quarter of a trillion dollars in debt over the next week, the announcement is out there, and while the bond market is selling off to a material degree equities could care less!

This is flat-out insane. At this run rate we would be trying to sell twelve trillion dollars over one year's time, an obviously ridiculous and impossible-to-peddle amount of debt at any price.
When does the rest of the world wake up (not to mention the primary dealers) and say "NO!"? Never? Is there a truly insatiable demand for our government's debt, despite the fact that President Obama got up on the national stage last night and promised to spend another trillion dollars we don't have?

How do equities power higher into this sort of debt issuance? Is it simply that the market has deduced that the government will hand all of this zero-interest money out - indefinitely?

Guess what - that which is impossible won't happen, and the stock market is now telling you that the impossible will become reality. There has been and will not be any amount of fiscal sanity on the part of our government until the market imposes it, and when it does it is going to happen in exactly the same way it happened to Bear Stearns, Lehman, Fannie and Freddie. May I remind readers that it was said that Fannie and Freddie "couldn't" get in trouble due to their implicit government guarantee? Well guess what - they both effectively failed, but when the US Government finds itself in the same situation it has nobody who can take it into conservatorship and as such we're just going to have to deal with the consequences of failed debt auctions - that is, dramatically increased funding costs across the board in the economy, including the government, which will choke off any hope of economic anything.

Folks, this is how you get detonation of a nation's monetary and political system. Timing the "event" it is not easy, but the certainty of outcome given this sort of outrageously irresponsible activity is not in doubt.

I'm increasing my stock of things that "will never go to zero" and keeping my ear to the ground. The "short the phone book but make sure you get out fast before you get trampled" moment approaches - mark my words.

U.S. Treasury Auction Fails - July 29, 2009

I have been watching the U.S. Treasury Bond/Note sales closely this week due to the sheer size of the offerings - $235 Billion. With all of the recent stimulus packages and bailouts - the question everyone is asking is – how much of our debt is the world willing to buy? Yesterday’s bond auction is the first indication that we’re in serious trouble.

‘Primary Dealers’ (Goldman Sachs, JPMorgan, etc.) of Treasury bonds/notes are required by the government to buy whatever is not sold. This hasn’t caused any heartburn for them in recent years because we’ve had ample demand for our bonds/notes – this is now changing. Primary dealers of yesterday’s auction were forced to buy a significant amount – which is why the auction effectively failed. Without primary dealer purchases, we would not have sold all of the bonds offered. It’s not hard to see why – our economy is unstable and our budget deficit of $1.8 trillion is flooding the market with our debt. Supply is outstripping demand. The U.S. government has been balance sheet insolvent for some time (liabilities exceeding assets) – our inability to sell bonds is the first step towards cash flow insolvency – bankruptcy and debt default. If you think things have been crazy over the past year – just wait until this gets out in the mainstream media. It doesn't help that the Treasury is selling another 28 billion in 7 year notes today and then quarterly refunding begins. Remember, just a few short months ago - our government was auctioning around $10-15 billion a week.

Many people who have kept an eye on Treasury auctions over the past year believe that it is entirely possible the Federal Reserve has been supporting Treasury Auctions directly (monetizing our debt). This is one reason they believe the Fed is opposed to an audit. I have attached a brief blog post below relating to this. It was posted yesterday. No one seems to know who is buying the bulk of recent auctions. In a truly free market - this wouldn't be a mystery.

Ladies and gentlemen, this is a very big shoe that just dropped. This is not theory or speculation - this is very real - and we are staring into a very real abyss. If the U.S. cannot fund its growing deficit - the party is over. No more low interest rates, no more stable currency, no more stock markets, no more ridiculous consumption rates, no more ridiculous budget deficits - and this will have a worldwide economic impact. Of course - most people have no real knowledge of what is happening below the surface due to all of the media spin - so our stock market continues to rise. At some point, it will be impossible to hide what is happening - and people will panic - and markets will fall. It seems that we have learned nothing from history. The parallels between now and 1929 are ominous.

Our economic system is collapsing - there's no other way to say it. The pace of collapse has recently slowed - but I believe we're now very close to being pushed off the ledge.

jg – July 30, 2009
________________________________
US 5yr Bond Auction Effectively FAILS

http://market-ticker.denninger.net

Wed. July 29, 2009

Posted by Karl Denninger

That's right, FAILS.

No, you didn't hear it reported this way and won't, but that's the math.

Here you have the results:

And here's the math:

1.923 BTC X 61.59% Primary Dealer bid = 1.18 BTC (PD), greater than 1.0. Or to put it a different way, but for the primary dealers the bid-to-cover was less than one, meaning that some of the issue would have been left on the table.

Thats a fail; but for the primary dealers the issue would not have subscribed.

Primary dealers are required to bid. That's the deal in exchange for their being named as "primary dealers." For this reason short of thermonuclear war you will never see an actual (BTC < 1.0) "fail" on a US Treasury Auction - Treasury has rigged the process so as to insure that cannot be reported. Therefore, the question is this: Less the primary dealer "bid" (forced by agreement) was there sufficient interest to subscribe the issue, and the answer is NO.

Those who think this is "no big deal" need to have their head examined. In general any BTC under 2.0 indicates a serious problem, and the perverse nature of the primary dealer system is the reason. The United States' Credit Card (issued by China and Japan) is being slowly cut off. That the stock market "recovered" after this ridiculously bad auction (bow-wow is the best way to describe it) speaks to the vacuum between the ears of both the cheerleaders in the mainstream media and those in the equity markets.

There is only one other time in recent memory that we've had a bond market auction fail like this. You might want to go have a look at your charts - with dates - for what followed shortly thereafter. They're going to try to sell 7yrs tomorrow, and then the real fun begins with the quarterly refunding.

That ought to be a real riot.

President Obama, you might want to have a chat with Bill Clinton about the Bond Market and Hillarycare, lest you wind up learning this lesson the hard way.

___________________________________

Nathan's Economic Edge

http://economicedge.blogspot.com/

Bond and dollar futures are both higher. Higher during a week that they are issuing $235 billion??? Now here’s my question… how do we finance $235 billion of bond auctions in one week – WHERE DOES THE MONEY COME FROM? Well, if we look at the bid results, we find that the Primary Dealers (PDs) are doing more and more buying each week. And when we look at the TIC data, we find that international buyers are doing more selling than buying. So, if the money to buy such massive issuances is coming from the PDs, then they have to be using their own cash or equivalents to buy them – correct?

So, let’s go and look at the balance sheets of the biggest Primary Dealers and see how much cash they possess… Let’s start with JPM. Here’s their balance sheet from their 2008 Annual Report, page 131:

It shows roughly $27 billion in immediate cash.

Now let’s look at the balance sheet of Goldman Sachs:

Here we find $35.4 billion of cash and cash equivalents. Hmmm… Okay, let’s say that the 5 biggest each have that amount – 5 times 35.4 = $177 billion. Of course they can’t place 100% of their cash and equivalents in long term bonds, so I would assume that only a fraction of that money would actually be available to buy at auctions. Of course there are their "trading assets" which we have no idea how they are used. But my premise is that week after week of $100 billion or now $200+ billion auctions cannot be supported by the money that the Primary Dealers possess.

So again, WHERE’S THE MONEY COMING FROM? Since I can’t see where the money is coming from, I’m going to throw a wild guess out there and say that the government and PDs are simply printing it as they go! How much? WAY, WAY more than the announced use of Bernanke’s $300 billion. Sound like a conspiracy theory? It is, and I invite the Fed, the Treasury, and the Primary Dealers to open their books and prove me wrong. I want to see a paper trail leading to the purchase of those bonds and treasuries!

This is a vitally important question to have answered for the future of our country – CRITICAL.

How the Federal Reserve is Monetizing Debt

If you’ve been paying attention to recent U.S. Treasury bond/note auctions, you’ve probably noticed that the amount of debt offered at these auctions is growing significantly. This is a direct result of our Federal Government’s spending on the numerous stimulus and bailout packages. To put the amount of debt in perspective – a year ago the U.S. would auction anywhere from $5 to $15 billion a week (on average). Last week the U.S. auctioned over $230 billion in Treasury bonds/notes.

Although our leaders in Washington act as though they have a blank check – it’s easy to see the repercussions of what they’re doing. The growing deficits are requiring the Treasury to auction more and more debt. The question becomes – at what point do we hold an auction where no one shows up to buy? As you’ve seen me say before – I (and others) believe this is already happening to some degree.

Personally, I believe the Federal Reserve has been supporting Treasury auctions for some time – but I could not figure out how they were doing it. Chris Martenson explains how they’re doing it in the article below.

You have to ask yourself – why all the secrecy? Why do they need to support our Treasury auctions? What happens if they stop supporting Treasury auctions?

The answers will lead you to one unpleasant conclusion – U.S. debt creation is unsustainable.

John – August 5, 2009

___________________________________

The Shell Game - How the Federal Reserve is Monetizing Debt

Sunday, August 2, 2009, 10:02 pm, by cmartenson (Chris Martenson)

Executive Summary
• The Federal Reserve and the federal government are attempting to "plug the gap" caused by a slowdown of private credit/debt creation.
• Non-US demand for the dollar must remain high, or the dollar will fall.
• Demand for US assets is in negative territory for 2009
• The TIC report and Federal Reserve Custody Account are reviewed and compared
• The Federal Reserve has effectively been monetizing US government debt by cleverly enabling foreign central banks to swap their Agency debt for Treasury debt.
• The shell game that the Fed is currently playing obscures the fact that money is being printed out of thin air and used to buy US government debt.

The Federal Reserve is monetizing US Treasury debt and is doing so openly, both through its $300 billion commitment to buy Treasuries and by engaging in a sleight of hand maneuver that would make a street hustler from Brooklyn blush.

This report will wade through some technical details in order to illuminate a complicated issue, but you should take the time to learn about this because it is essential to understanding what the future may hold.

One of the most important questions of the day concerns how the dollar will fare in the coming months and years. If you are working for a wage, it is essential to know whether you should save or spend that money. If you have assets to protect, where you place those monies is vitally important and could make the difference between a relatively pleasant future and a difficult one. If you have any interest at all in where interest rates are headed, you'll want to understand this story.

There are three major tripwires strung across our landscape, any of which could rather suddenly change the game, if triggered. One is a sudden rush into material goods and commodities, that might occur if (or when) the truly wealthy ever catch

on that paper wealth is a doomed concept. A second would occur if (or when) the largest and most dangerous bubble of them all, government debt, finally bursts. And the third concerns the dollar itself.

In this report, we will explore the relationship between those last two tripwires, government debt and the dollar.

Replacing private credit with public credit

Our entire monetary system, and by extension our economy, is a Ponzi economy in the sense that it really only operates well when in expansion mode. Even a slight regression triggers massive panics and disruptions that seem wholly inconsistent with the relative change, unless one understands that expansion is more or less a requirement of our type of monetary and economic system. Without expansion, the system first labors and then destroys wealth far our of proportion to the decline itself.

What fuels expansion in a debt-based money system? Why, new debt (or credit), of course! So one of the things we keep a very close eye on over here at Martenson Central, as they do at the Federal Reserve, is the rate of debt creation.

One of the big themes in the current credit bubble collapse is the extent to which private credit has been collapsing and the corresponding degree to which the Federal Reserve has been purchasing debt and the federal government has stepped up its borrowing. In essence, public debt purchases and new borrowing has attempted to plug the gap left by a shortfall in private debt purchases and borrowing.

That's the scheme right now - the Federal Reserve is creating new money out of thin air to buy debt, while the US government is creating new debt at the most fantastic pace ever seen. The attempt here is to keep aggregate debt growing fast enough to prevent the system from completely seizing up.

How are they doing?

The debt gap

One of the great perks of living in a relatively open society is that we generally get access to pretty good information. The Federal Reserve routinely publishes a document called "Monetary Trends," where they collapse all their points of interest into a nice, tidy collection, and then make it available for all to see.

Here's what caught my eye in the most recent one:

What we see here is federal debt (bottom chart) exploding at a nearly 30% yr/yr rate of change in response to a collapse in corporate and consumer borrowing (top charts).

This raises a most interesting question: "Who is lending the money to accommodate all that federal borrowing?"

Here's where the story gets interesting.

Treasury International Capital (TIC) flows

Lately, a number of observers have made note of a troubling decline in foreign demand for US paper assets, notably bonds. Worse, it's even turned into outright selling which will ultimately translate into dollar weakness.

The relative demand for the dollar "out there" in the international Foreign Exchange (or "Forex") market directly impacts the dollar's strength. If there are more sellers then its value will fall; if there are more buyers, then its value will rise. One way to assess this delicate balance is to ask, "In total, are foreigners buying or selling US assets and what are they doing with those proceeds?"

Luckily for us, the exact answer to this very question is released in a monthly report put out by the Treasury Department, called the Treasury International Capital Flows report, or TIC report for short.

The recent TIC reports have been quite alarming, because they not only reveal the most sudden deceleration in flows in history, but also that they have been negative for some time now. This chart is from the Federal Reserve:

What we see here is that from the early 1990's onward until 2007, foreigners bought progressively more and more US assets and did so by bringing their money to the US and leaving it there. It is only over the past seven months, out of decades, where that process has reversed and become negative. This is a significant event, to say the least.

On the surface, the above chart hints at a potential disaster for a country that is embarking on the largest-ever federal debt binge in history.

After all, if US assets are being shunned by foreigners, how will we find enough buyers? And what will happen to the dollar?

The answers are: "We won't" and "Nothing good."

Digging in

If we dig into deeper into the detail of the report, we find something even more interesting. While the overall flows have been negative, there is an enormous difference between the behaviors of foreign central banks and private investors. Fortunately the TIC report distinguishes between these two broad classes of buyers.

Since the start of 2009 and continuing through the month of May, private investors sold $364 billion dollars worth of US assets, while central banks purchased $50 billion dollars worth (source is a .csv file available here from the Treasury). Added up, some $314 billion dollars of foreign money has left the country since the start of the year.

What this demonstrates is the utter reliance of the entire house of cards upon the continued purchase of US financial assets by foreign central banks. Without the continued cooperation of the foreign central banks in accumulating US assets, suffice it to say that the dollar will fall a lot lower than it already has.

The dollar

Not surprisingly, the dollar recently put in a new closing low for the year (YTD 2009) and is approaching a major area of support and resistance. If it breaks through, we could be looking at a rapid game-changer here.

Of course, I've said all this before, and every time we seem to get close, there's been an upside surprise in store. The forces aligned to prevent a dollar collapse are numerous.

But the same risk remains, and the fundamental picture concerning the dollar has not changed since I first became wary of its fortunes in 2002. In fact, it's grown worse. Federal deficits are higher than I ever imagined possible (13% of GDP!), and now the TIC flows are negative. The only somewhat bright(er) spot is that the trade deficit has shrunk quite a bit. However, it, too, remains solidly in negative territory, meaning it continues to apply pressure to the value of the dollar by increasing the total number of dollars that need to find a quiet resting place outside of the country.

Treasury auctions

During this past business week (July 27th - 31st, 2009), the US Treasury auctioned off more than $243 billion worth of various Treasury bills and bonds. "Indirect bidders," assumed to be mainly central banks, took an astonishing 39% of the total, or nearly $95 billion worth.

With the exception of the 5-year auction, which mysteriously stank up the joint with a worrisome bid-to-cover ratio well below 2.0 (the bond market behaved poorly upon the release of that news item), the story here is that foreign central banks are buying up vast quantities of Treasury offerings.

Wait a minute, hold on there…I thought we just talked about how the TIC report said that foreign central banks have only bought $50 billion in total US paper assets through May - and now they are said to be buying $95 billion during a single week in July alone?
Something is not adding up here.

To understand what, and to get to the essence of the shell game, we need to visit one more source of information - something called the Federal Reserve Custody Account.

The Federal Reserve Custody Account

It turns out that when China's central bank (or any other foreign central bank) decides to buy either US agency or Treasury bonds, they do not walk up to some window somewhere, hand over a pile of cash, and then take some nice looking bonds home with them in a suitcase.

Instead, what happens is that the Federal Reserve actually holds the bonds (or rather an electronic entry representing the bonds) in a special account for these various central banks. This is called the "Custody Account" and it holds US debt 'in custody' for various central banks. Think of it as a magnificently vast brokerage/checking account, run by the Federal Reserve for central banks, and you'll have the right image.

Although the TIC report shows flows of capital into and out of the country, it does not show you what is going on with those funds that are already in the country. If you look again at the first chart in this report, and behold the vast flows of money that came into the US between 1995 and 2008, you can get a sense of how much money got sent to the US and mostly remains parked there.

The custody account currently stands at $2.787 trillion (with a "t") dollars. It has increased by over $430 billion the past 12 months and by more than $275 billion in 2009 alone (through July 29). These are truly shocking numbers, and they tell us that foreign central banks have been accumulating US debt instruments throughout the crisis.

As we can see in the chart below, there has been absolutely no deflection in the growth of the custody account as a consequence of the financial crisis, bottoming trade, or the local needs of the countries involved. It's almost as if the custody account is completely disconnected from the world around it. If you can spot the credit bubble crisis on this chart, you have sharper eyes than me.

What does such a chart imply? We might wonder what sorts of distortions are created by having such a massive monetary spigot aimed from several central banks towards a single country. We also might question just how sustainable such an arrangement really is. It is a complete mystery how such a chart can display nary a wiggle, despite all that has recently transpired.

This next table showing the yearly changes in the custody account actually surprises me quite a bit.

Despite everything that's been going on, the custody account is on track to grow by the largest dollar amount on record this year, nearly $500 billion dollars (if the current pace continues). Where is all this money coming from and for how much longer?

Understanding the gap between the TIC and the Custody numbers

One thing you might have noticed is that the TIC report only shows $50 billion in foreign bank inflows for 2009, while the custody account grew by $277 billion.

How is it possible for the TIC report to show smaller inflows than growth in the custody account? We can see that clearly in this table, which compares the two. (Note: These are 12 monthly yr/yr changes, so the numbers will be different than the YTD numbers I just cited):

One explanation is that the custody account, at some $2.7 trillion dollars, is accumulating a lot of interest. If those interest payments are not "sent home" and remain in the account, then the account will grow by enough to more or less explain the difference. For example, the $135 billion difference shown above could be generated by a 5% return to the custody account, which is not an unthinkable rate of interest for that account.

International check kiting

Some people view the custody account as nothing more than an elaborate version of check kiting, played at the central banking level.

Check kiting

An illegal scheme whereby a false line of credit is established by the exchanging of worthless checks between two banks. For instance, a "check kiter" might have empty checking accounts at two different banks, A and B. The kiter writes a check for $50,000 on the Bank A account and deposits it in the Bank B account. If the kiter has good credit at Bank B, he will be able to draw funds against the deposited check before it clears, i.e., is forwarded to Bank A for payment and paid by Bank A. Since the clearing process usually takes a few days, the kiter can use the $50,000 for a few days, and then deposit it in the Bank A account before the $50,000 check drawn on that account clears.

In this game, Central Bank A prints up a bunch of money and buys the debt of Country B. Then the central bank of Country B prints up a bunch of money and buys the debt of Country A.
Both enjoy the appearance of strong demand for their debt, both governments get money to use, and nobody is the wiser. Except that the world's total stock of central bank reserves keep on growing and growing and growing, as reflected in the custody account, which will someday result in thoroughly unserviceable amounts of debt, an unmanageable flood of money, or both.

If this strikes you as a scam, congratulations; you get it.

If that was all there was to the story, then it would be far less interesting than it actually is. When we dig into the custody account data, we find that the total picture is hiding something quite extraordinary. Even as the total custody account has been growing steadily and faithfully, the composition of that account has been changing dramatically.

Here we note that agency bonds peaked in October of 2008 at nearly a trillion dollars but have declined by $178 billion since then. Treasuries, on the other hand, have increased by over $500 billion over that same span of time. A half a trillion dollars! If you were wondering how the US bond auctions have managed to go so smoothly, here's part of your answer.

What is going on here? How is it possible that central banks are buying so many Treasury bonds, at the fastest rate of accumulation on record?

It would appear that foreign central banks have been swapping agency bonds for Treasury bonds, but that's not how the markets work. First, they would have to sell those bonds, before they could use the proceeds to buy government debt. So to whom did they sell those Agency bonds in order to afford the Treasury bonds?

Here we might recall that the Federal Reserve has been buying agency bonds by the hundreds of billions.

The shell game

Have you ever seen a sidewalk magician run the shell game, where a pebble under a shell is magically shuffled around - now you see it under this shell, now you see it under that shell, now it disappears completely - or does it? The more it moves around, the more confused you get. If you can only figure out which shell the pebble is hidden under, you win! But where is the pebble? The point of the game, from the perspective of the street hustler, is to use complexity of motion to confuse the mark.

These are the three critical points to remember as you read further:

1. The US government has record amounts of Treasuries to sell.

2. Foreign central banks, which have a big pile of agency bonds in their custody account, would like to help but want to keep things somewhat under the radar to avoid scaring the debt markets.

3. The Federal Reserve does not want to be seen directly buying US government debt at auctions, because that could upset the whole illusion that there is unlimited demand for US government paper, but it also desperately wants to avoid a failed auction.

For various reasons, the Federal Reserve cannot just up and start buying all the Treasury paper that becomes available in record amounts, week after week, month after month.

Instead, it uses this three-step shell game to hide what it is doing under a layer of complexity:

Shell #1: Foreign central banks sell agency debt out of the custody account.

Shell #2: The Federal Reserve buys those agency bonds with money created out of thin air.

Shell #3: Foreign central banks use that very same money to buy Treasuries at the next government auction.

Shuffle, shuffle, shuffle, shuffle, shuffle, SHUFFLE, shuffle! Confused yet?

Don't be. If we remove the extraneous motion from this strange act, we find that the Federal Reserve is effectively buying government debt at auction. This is exactly, precisely what Zimbabwe did, but with one more step involved, introducing just enough complexity to keep the entire game mostly, but not completely, hidden from sight. They can scramble the shells all they want, but the pebble is still there somewhere - the pebble being the fact that the Fed is creating money to fund the purchase of US debt.

At the time, the Federal Reserve program to purchase agency bonds was described like this:

Fed to Pump $1.2 Trillion Into Markets

Greatly Expanded Purchases Are Designed to Lower Interest Rates, Stimulate Borrowing
The Federal Reserve yesterday escalated its massive campaign to stabilize the economy, saying it would flood the financial system with an additional $1.2 trillion.

In its statement yesterday, the Fed said it will increase its purchases of mortgage-backed securities by $750 billion, on top of $500 billion previously announced, and double, to $200 billion, its purchases of [Agency] debt in housing-finance firms such as Fannie Mae and Freddie Mac.

While "stimulating borrowing," "stabilizing the economy," and "lowering interest rates" are laudable goals, the primary goal of the program seems to have been something else entirely - to assure plentiful funds for the massive US Treasury auctions coming due. I saw nothing in any article I read about this program that even suggested that one of the goals was to allow foreign central banks to effectively swap their agency debt for US government debt using money printed from thin air. But that's clearly one of the outcomes.

The Federal Reserve, for its part, has been quite open about these purchases of Agency debt. It even provides an excellent website with nice graphics, allowing us to track the purchase program.

However, this openness only extends to the amounts themselves, not the source(s) of those Agency bonds. This is, in my mind, yet another reason the Fed desperately wishes to avoid an audit. The results would expose the game for what it is.

As we can see in the above chart, the Fed has purchased more than $640 billion of Agency bonds, and has promised to buy more in the near future.

As we now know, at least some of that money has been recycled into US government debt, where "indirect bidders" have been snapping up an unusually high proportion of the recent offerings. (Note: The way Indirect bidders are calculated has recently changed, and I am not entirely clear on how much this influences the numbers we now see….I'm working on it).

A fair question to ask here is, "If there are green shoots everywhere and the stock market is racing off to new yearly highs, why is the Fed continuing to pump money into the system at these mind-boggling rates?" One answer could be, "Because things might not be as rosy as they seem."

Conclusion

The Federal Reserve has effectively been monetizing far more US government debt than has openly been revealed, by cleverly enabling foreign central banks to swap their agency debt for Treasury debt. This is not a sign of strength and reveals a pattern of trading temporary relief for future difficulties.

This is very nearly the same path that Zimbabwe took, resulting in the complete abandonment of the Zimbabwe dollar as a unit of currency. The difference is in the complexity of the game being played, not the substance of the actions themselves.

When the full scope of this program is more widely recognized, ever more pressure will fall upon the dollar, as more and more private investors shun the dollar and all dollar-denominated instruments as stores of value and wealth. This will further burden the efforts of the various central banks around the world as they endeavor to meet the vast borrowing desires of the US government.

One possible result of the abandonment of these efforts is a wholesale flight out of the dollar and into other assets. To US residents, this will be experienced as rapidly rising import costs and increasing costs for all internationally-traded basic commodities, especially food items. For the rest of the world, the results will range from discomforting to disastrous, depending on their degree of dollar linkage.

Under these circumstances, "inflation vs. deflation" is not the right frame of reference for understanding the potential impacts. For example, it would be possible for most of the world to experience falling prices, even as the US experiences rapidly rising prices (and hikes in interest rates) as a consequence of a falling dollar. Is this inflation or deflation? Both, or neither? Instead, we might properly view it as a currency crisis, with prices along for the ride.

Further, all efforts to supplant private debt creation with public debts should be met with skepticism, because gigantic programs are no substitute for the collective decisions of tens of millions of individuals and cannot realistically meet millions of individual needs in a timely or appropriate manner.

The shell game that the Fed is currently playing does not change the basic equation: Money is being printed out of thin air so that it can be used to buy US government debt.

My advice is to keep these potential issues and insights in sharp focus, make what moves you can to diversify out of dollars, and be ready to move rapidly with the rest. This game is far from over.

Polish Bond Auction Failure

Personally, I believe this is the inevitable future for the U.S. and every other nation with a ‘modern’ economy based on a fiat currency (which is just about everyone). As Chris mentions below – these things tend to start at the periphery (smaller economies) and progress towards the center (affecting everyone). The U.S. has prevented this (so far) by printing a ton of new dollars. The question is – how long can this last?

I think we’re seeing the result of these actions with the recent decline in the value of the dollar:

                                      (U.S. Dollar Index)

______________________________________________________
From the Outside In: Polish Bond Auction Failure

Thursday, September 10, 2009, 11:39 am, by cmartenson

In the continuing theme of keeping our eye firmly fixed to the periphery of the financial universe for clues that things are about to change, we note that Poland recently suffered a bond auction failure.

Why doesn't Poland just print up the money from their central bank and buy them themselves like the US and the UK?

I don't really know. When the Federal Reserve does this there seems to be no impact on the dollar, interest rates, or bond prices, so perhaps the Polish central bankers should go to the US for a tour of the facilities and see which buttons they need to push and in which order to accomplish the miracle results of the US.

Sell Polish Bonds on Worsening Finances, BNP Says

Sept. 10 (Bloomberg) -- Investors should sell Polish government bonds because of a “very dangerous” fiscal outlook for the country, BNP Paribas SA said.


Polish bonds weakened and the zloty fell after investors bought just over half the five-year notes on offer from the Finance Ministry yesterday in the first auction since the government said the budget deficit will almost double next year.

All (slight) sarcasm aside, I would count this as a troubling sign from the periphery; an indication that perhaps difficulty is headed towards the center. For new members, I've written about this concept (here) and dedicated a podcast to it (here).

For now the US is managing to print up vast gobs of fresh money (actually its electronic equivalent) and using this to support a truly massive fiscal deficit without any apparent ill effects.

The level of interlocking coordination between Wall Street and the Fed required to pull this off is really something to behold. While interesting, I really only care about when the arrangement will cease to work.

How do I know it will someday end? Because no culture has ever figured out how to print its way to prosperity, only to ruin.

Tepid U.S. Treasury Auctions - Yields Climb

It would appear that U.S. Treasury auctions this week have caught the eye of the financial world.


What today’s auction means:

1. Treasury Yields (and therefore - interest rates) continue to move higher

2. Treasury prices are moving lower (bond prices always move inversely to yields)

3. Demand (especially foreign demand) appears to be weakening (Bid to cover)

4. The weak 5 year auction yesterday – does not appear to be a one-time event

All of this is not unexpected for a nation running massive budget deficits – and is forecasting massive deficits for the foreseeable future (there are some smart investors out there). Since we all know that we’re not fixing the deficit problem any time soon (see ‘universal healthcare’) – there is a high probability that the situation will worsen in coming weeks/months. If this situation continues to deteriorate to the point that a U.S. Treasury auction fails (bid to cover less than 2.00) – all kinds of unpleasant things will begin happening. Imagine all of our leaders in Washington D.C. (Republican and Democrat) trying to deal with a budget deficit of over $1 trillion – and no way to finance. If you think the majority of our leaders are inept now – just wait until we see a real crisis.

A few months ago – Chris Martenson targeted the end of March/beginning of April as the time he expected the next phase of this crisis to begin. There were a few reasons – but the main reason was that the Federal Reserve’s ‘program’ of supporting the housing market by buying Mortgage Backed Securities would end by April 1st. That program is ending as expected.

There is always the possibility that the Fed will step in with additional ‘programs’ to support the housing market and low interest rates – but most of the rhetoric I’ve listened to lately has been centered on removing government/central banking support from the world’s economy.

So – with the Fed ending massive programs ($1.25 trillion of MBS purchases & possibly ending Treasury purchases) aimed at supporting our housing market and low interest rates – and the U.S. Government continuing to flood the market with debt - the risk for higher interest rates is increasing significantly.

From an investment standpoint – we need to consider what higher interest rates could do:

1. What happens to an anemic housing market if mortgage rates increase significantly?
2. What happens to big ticket purchases (like cars) if rates increase?
3. What happens to stock markets if the flow of cheap money stops?
4. What happens to overall bank lending if interest rates increase significantly?
5. If bank lending continues to contract – what happens to our money supply?
6. If our money supply contraction continues to accelerate – what happens to our economy?

If you or someone you know is considering a purchase requiring a loan of any type – now is the time to make a decision.

jg - March 25, 2010
_________________________
$32 Billion 7 Year Auction Closes At 3.374%, Very Weak Auction With Huge Tail

Submitted by Tyler Durden on 03/25/2010 12:04 -0500

Zerohedge.com

• $32 Billion 7 Year closes at 3.374%, allotted at high 83.04%, previous at 3.078%!

• Bid To Cover at 2.61, Previous at 2.98, average overpast year 2.67

• Indirect Take Down 41.87; Direct Take Down 8.11%

• Indirect Hit Rate 82%

• When Issued was trading at 3.338%, a massive tail

• 10 Year about to break 3.90%

The chart says it all:

______________________________
CREDIT MARKETS

MARCH 25, 2010, 5:03 P.M. ET

Tepid Sale Weighs on Treasurys; 10-Year Yield Climbs

Wall St. Journal

NEW YORK—Prices of most Treasury notes and bonds were lower after relatively tepid demand on a sale of $32 billion in seven-year notes, sending the 10-year note's yield to its highest level since June.

The auction wrapped up this week's $118 billion new government note supply. Demand for this round of debt supply, including $44 billion in two-year notes and $42 billion in five-year notes, was weaker than in recent sales, underlining some concern that appetite for government debt could wane given the onslaught of debt supply to fund the high level of budget deficit and fiscal stimulus to revitalize the economy.

Without strong demand on auctions, bond yields could rise significantly, increasing borrowing costs for the U.S. government, consumers and companies. Already, fiscal problems in Greece have caused a downgrade in its sovereign credit ratings, increasing interest rates and undermining its economic outlook. Major ratings agencies have also warned the U.S. government that it has to address its budget shortfall to maintain its highly prized triple A credit ratings in the longer term.

"The weightiness of supply finally broke the camel's back," said James Caron, global head of interest-rate strategy at Morgan Stanley in New York.