Monday, December 15, 2008

Who is the Pilot on this Flight to Safety?

If you are like me you have probably been asking yourself who would buy T-Bills with a 0% yield; it just does not make sense. The popular answer is "Treasuries are experiencing a flight to safety," but who is the pilot? The US Treasury released Treasury International Capital (TIC) data on Monday. The TIC data showed a disturbing trend for holders of long term US Treasury securities, while also explaining why short term Treasuries have been doing so well.

In October, foreigners sold $34 billion of long term treasury securities, while purchasing $92 billion of short term treasuries. The treasury has kept tabs on foreign purchases of US debt since 1978 and the amount of long term securities sold in October 2008 was second only to August of 2007 when foreigners sold $37 billion. But, foreigners bought short term securities so all is well, right?

It is no secret that foreign buyers of Treasury securities have been one reason the US has been able to sustain a large debt load. In fact, foreign buyers have kept up pace with the rate of change of debt issuance.

Even with the unprecedented run-up in outstanding US debt, foreign investors have not lost their appetite for T-bills, notes, and bonds. The chart illustrates the rate at which foreigners have bought new debt has outpaced the rate at which the US Treasury has issued debt. However, the gap appears to be narrowing and this could be cause for concern.

Despite the recent frenzied buying of short term securities, the percentage of US debt owned by foreigners has been declining since the start of the credit crisis in July 2007.

On aggregate, foreigners have been buying fewer Treasury securities as a percentage of all marketable debt outstanding. If the US plans on increasing its debt load then foreign investors must reverse this trend. The continued divergence of these two lines means only one thing: higher interest rates. Probably the easiest way to think of this chart is supply (outstanding debt) vs demand ( foreign ownership of debt). Econ 101 tells us that if demand falls and supply increases, then price decreases. In terms of US debt, lower prices mean higher interest rates. If another buyer steps into the market then higher interest rates are not inevitable.

In October, as part of the Emergency Economic Stabilization Act, the Congress approved a debt limit increase to $11.3 trillion. Currently the national debt stands at $10.6 trillion. If the US maxes out its credit line (a highly likely scenario) that would translate into a 7% increase in debt outstanding. Since foreigners are not the only buyers of US debt, someone will have to fill that gap, especially if the decline in foreign ownership continues. The trillion dollar question is, will the new buyer agree to the same 0% terms that the current buyers are receiving?

Disclosures: I am long US Treasury Bonds (for now).

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