Wednesday, June 22, 2011

Buy, Buy Bonds!

Federal Reserve Chairman Ben Bernanke announced today that the Fed remains on track to withdraw from the Treasury market at the end of the month.  Over the past 8 months the Fed is estimated to have bought about 85% of the U.S. Treasury's securities offerings that were needed to fund government operations.  That was about $600 billion in total under the so-called QE II program.

The big question now is where is the money going to come from to buy the Treasury bonds over the remainder of the year?  Since we are running a deficit of over $1.5 trillion this year that means the Treasury needs to find purchasers for our debt to the tune of $750 billion over the next 6 months.

China stopped buying U.S. Treasuries once the QE II program began.  Will they start buying again?  Russia's central bank recently stated that it has decided to "actively sell US Treasuries".  If they are selling why would they want to buy?  Europe has their own problems with Greece.  Will they be bailing us out at the same time by buying our debt?

John Mauldin's "Outside The Box" newsletter had Simon Turner from Economic & Copper Advisory Services in London as a guest columnist this week.  Here is his take on the end of QEII and it potential ramifications.

The Federal Reserve is likely to sit pat for some months to see how the US economy will be able to perform without the steroids provided by them. Foreign central banks have largely been absent from Treasury auctions. In quarter 1 this year, foreign central banks bought just 16% of the issuances while the Federal Reserve acquired almost 200%, according to Russell Napier. In other words, the Fed’s activities have masked the exodus of foreign central banks including China from these auctions.
If foreign central banks continue to abstain from purchasing US Treasuries, the private sector will have to fund the fiscal deficit, implying quarterly remittances to the US Treasury of some $370bn. The private sector will be able to fund these auctions but at a price. They will demand a higher return on treasury paper and the funding will mean that the free-flow of funds into equity and commodities will come to an end. Many institutions are taking risk off the table.
On our associate’s, WaveTrack International technical work, 10-year US Treasuries should be yielding around 4% later this summer and 6% a year or so later. The repercussions of such a change in the yield structure will have global consequences, not least on stock and commodity markets.
In other words, all signs point for a rough period directly ahead of us.   As I have written over and over, it is time to step up.  However, no one ever wants to take their medicine.  You see it in the Greek streets. You see it in California.  It is no difference in the City of Cincinnati.  That is why I have so much respect for Paul Ryan for being a quarterback rather than a punter. See my post of February 20, 2011.

Turner sees the same looming issues.  He also is not optimistic that we will do what needs to be done until we are in deep crisis. However, if we get our act together and return to the principles that made America great in the first place, there is an excellent opportunity for an American Renaissance.

The USA does not only have a cyclical problem, but a structural one also. The fundamental issue is that sooner rather than later government will be forced to introduce measures that will allow the country to live within its means. It will take a deep crisis before such policies can be put together and passed by the country’s politicians. For instance, a run on the US dollar sometime next year or early in 2013 might do the trick.
Unemployment amongst teenagers has become a serious structural and social problem for the USA in an economy that is becoming dominated by skilled workers. The number of unemployed teenagers (16-19) now totals almost one in four. However, the number of African-American, not seasonally adjusted U-3 unemployment, including both sexes, in the same age group has risen to a stunning 41%, almost every other teenager.
Once Washington puts its act together, (it will have to or else the crisis will get so deep that US markets will become dysfunctional), America will find a large number of companies which had vacated the shores of the USA for China and other parts of Asia returning to their homeland.
There are two main reasons for this change, what we call reverse globalisation. First, manufacturers want their supply chains located close to the market, not on the other side of the world. And second just as important is the cost differential trend which is narrowing together with the increasing logistical costs. It is not only the wage profile looking 10 years forward, but the other costs, such as land, electricity, taxes together with the indirect supply chain cost increases. There is also the reluctance of the system in China to allow foreign companies to gain access to government contracts.
Within a decade, the USA could supplant China as the manufacturing hub of the world. To repeat, big changes will be needed in Washington for this historic development to occur. The changes will not just be on the fiscal side, but the need to offer businesses the right incentives to produce in the USA rather than abroad, the permitting procedures to allow the development of the country’s resources, including oil (the USA could become self-contained), making government less intrusive in households and businesses and so on.
In short, it is putting back in place the principals that made America the great country it once was. Crises produce opportunities and this one is as big as they have been since the USA entered WW11. What is noteworthy is that should America grab its opportunity, it will become self-contained in energy and of course food. What other major power has those valuable twin assets?
We have them.  I just don't understand government policies that don't allow us to take advantage of our assets.  For starters, we need a President that is more interested in developing our energy resources than Brazil's.  It would also help if we did not have the NLRB trying to stop the construction of a new Boeing  plant in South Carolina.

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